Two Basic Strategies for Estate Planning

About a year ago, Joe, a long-time reader of this column and the owner of a family business called Success Co., hired a new CPA, Claude. At one of their initial meetings, Joe showed Claude a thick file of printouts of articles from this column, which he had been saving for years. Claude studied the articles, but like many professionals, he wasn’t sure exactly how to implement the strategies described in them. “Let’s call Irv,” he suggested to Joe. They did, and together we decided on a couple of the strategies that best addressed Joe’s estate planning needs.

Strategy #1: Increase tax-free wealth with life insurance. There is a myth that if you no longer make out-of-pocket payments to an insurance company, you are no longer paying premiums. It is true that if you have built up enough cash surrender value (CSV) in one or more life insurance policies (or in your spouse’s policy or a second-to-die policy), you are no longer paying cash premiums to the insurance company. But you are, in fact, still paying premiums—they’re just coming out of your CSV. 

Joe, age 76, and his wife, Mary, age 67, owned four policies with a combined CSV of $1.485 million and a combined death benefit of $2.04 million. They were no longer paying cash premiums on any of the policies. My insurance guru was able to replace those existing policies, using a tax-free exchange, with new policies that have death benefits totaling $2.9 million, a 42-percent increase. And these new policies don’t require one penny in cash premiums, now or in the future. 

Sometimes the best insurance strategy is to dump single life policies and buy second-to-die policies. Joe and Mary could have acquired a $3.65 million second-to-die policy, all taxes paid in full, using only their $1.485 million CSV.

Strategy #2: Establish a comprehensive estate plan. A comprehensive plan is actually two plans: 1) the traditional A/B trust (often called the “family” or “marital” trust) with a pour-over will and 2) a lifetime plan. Without the lifetime plan, the traditional plan is actually a “death plan,” meaning nothing happens until after you die.

A lifetime plan contains a number of sub-strategies that allow you to totally conquer estate taxes and often uses some strategies that invest a portion of your current wealth to fund the creation of significant additional wealth. This wealth then can pass to your heirs free of taxes. The most important sub-strategies we implemented for Joe were:

• Family limited partnership (FLIP). We created a FLIP and transferred a little more than $6 million of Joe’s investments (CDs, cash, stocks, bonds and real estate) into it. Joe retains 
1 percent of his company in the form of all voting rights (and therefore also maintains operating control of the company), while the remaining 99 percent (called “limited units”) can be gifted to his children and grandchildren. The tax laws allow a discount of about 35 percent on the value of the investments in the FLIP, reducing the $6 million to $4 million for tax purposes (and therefore saving in estate taxes on that $2 million difference).

• Gifting program. Every year, Joe and Mary will each gift the maximum allowable amount ($14,000) to each of their children and grandchildren. The combined $28,000 that each heir receives is tax-free.

• Management company. We created a management company (a C corporation) that is not related to Success Co. for tax purposes. This new company can provide fringe benefits to Joe and his son Sam, who also works for Success Co., without providing those same benefits to other Success Co. employees. This makes deductible 100 percent of medical and long-term care expenses for Joe and Sam’s families, for example. Total annual savings from this strategy amounts to about $21,000.

• Sale of annuities to charity. Joe had $850,000 in various annuities. As a practical matter, if he kept these annuities until his death, they would amount to really terrible insurance policies. Instead, we donated the annuities to a charity and were able to realize a $239,000 charitable deduction. Best of all, we are using the annual annuity payments received from the charity to pay for a $4 million second-to-die life insurance policy on Joe and Mary. So, it’s really a triple play: $850,000 is removed from Joe’s taxable estate; a $239,000 charitable deduction is realized; and $4 million from the insurance policy will go to Joe’s heirs tax-free, because the policy will be owned by an irrevocable life insurance trust (ILIT) that we also set up.

By the time we were finished crafting Joe’s comprehensive estate plan, we had not only eliminated all of Joe’s potential estate tax, but had significantly increased the amount of wealth that his family will receive after his death.