YOU ARE ABOUT to read a real-life, tax-war story. Joe, a reader of this column from Wisconsin, founded and ran his family business, Success Co., for 28 years. His son Sam has been running the business for seven years and doing a great job. Joe, age 66, has cut back his working time to three to four hours a day for eight months of the year. The other four months are spent in Florida.
Over the years to help Success Co. grow, Joe took only enough salary to maintain his family’s lifestyle. Profits were not taken out of Success Co. but were reinvested. The business is still profitable but, unfortunately, Joe’s salary is his only source of income. Success Co. is a C corporation (a tax-paying corporation).
In the past, because of the rather modest salary, Joe would take a big year-end bonus (when profits were available) from time to time to fund large family cash requirements (college, vacations, condo, etc.). His professionals had advised him to continue this compensation practice — the same salary and bonus arrangement — even though Joe was putting in about one-third of the time he worked in prior years. Joe was not comfortable with this advice and called me for a second opinion.
The IRS could attack Joe’s current compensation arrangement on two fronts: First, the bonus would be regarded as a dividend, because it is not taken until just before the end of the year when the amount of profit can be easily determined; and second, the salary would be regarded as unreasonable compensation.
Would the IRS win? On the first attack, Joe and Success Co. would not stand a chance. The IRS would win hands down, with the result being a nondeductible dividend for Success Co. and a taxable dividend to Joe.
Second, the IRS could probably knock out about half of Joe’s salary as being unreasonable compensation, but this salary issue (really a dangerous and unnecessary tax risk) is tough to pin down with any certainty.
What should Joe do? He needs the current income to maintain his lifestyle. The answer is to kill the C corporation and elect S corporation status. This would automatically remove the unreasonable compensation problem.
What about the bonus? With his firm an S corporation, Joe would own 100% of the stock and could take a tax-free dividend from Success Co. (up to the full amount of S corporation profits). This means that Success Co.’s profits would only be taxed once when taken as an S corporation dividend, instead of twice, when taken from a C corporation. A big tax saving! Better yet, the same trick — tax-free dividends — will continue to work when Joe completely retires.
One more thing: S corporation dividends (the economic equivalent of a bonus to Joe) are not subject to payroll taxes. Another big tax saving. And here’s an extra bonus: Joe can transfer Success Co., because it is an S corporation, to Sam completely tax-free using a wonderful strategy called an “intentionally defective trust.”
Avoiding probate is nice, but ...
Everyone seems to have the same target: lower my estate taxes. Forget about the poorly done estate plans. Let’s talk about the typical, well-done traditional “estate plan.”
These traditional plans seem to have two targets: avoid probate and reduce the estate tax. The bulk of them use only three very basic strategies:
- A revocable trust (more often called a “living trust”) may avoid probate but it cannot save one cent of taxes (not income tax, gift tax or estate tax).
- A two-trust arrangement — usually called “Trust A” and “Trust B” or “Marital Trust” and “Family Trust” or something similar — which is used by a married couple to get the first $2 million (assuming survival until 2011) of their estate tax free.
- Some form of the marital deduction, which is simply a tax deferral, because no tax is due at the death of the first spouse, say, the husband. But when the wife dies, the IRS collects its pound of flesh.
That’s it. Three strategies. But note, each strategy is designed to offer tax savings only after you die. The rest of the typical traditional estate plan, as far as tax savings are concerned, is usually boilerplate or does not address the many other tax-saving possibilities available.
Only about one of every five estates we review in our office contains even one more tax-saving strategy beyond the above three basic strategies.
The key to whipping the estate tax collector, legally, is not death planning, but lifetime planning. Remember, you ain’t dead yet.
I want every reader of this column to do two things:
1) Do lifetime planning. This involves strategies such as gifts to your kids, create an irrevocable life insurance trust and pay your life insurance premiums using funds in your profit-sharing plan, 401(k) or IRA, and
2) Change your overall target from just reducing your estate tax to passing all your wealth — intact and tax-free — to your family. This involves strategies such as transferring your business tax-free to your kids using an intentionally defective trust and creating a family limited partnership to hold your real estate and other investments.
Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL 60606; tel. 312/207-1040, or via e-mail at [email protected].