The risks of an outdated estate plan

Theodore Roosevelt, the 26th president of the United States, said it: "In any moment of decision, the best thing you can do is the right thing. The next best thing is the wrong thing. And the worst thing you can do is nothing."

This is the story of two brothers, Joe and Moe. Joe, now age 68, did the right thing by creating his estate plan at an early age, monitoring it and updating it as necessary.

Moe, now age 72, on the other hand, was a champion procrastinator. As you will see, he did very little estate planning and what he did was out of date. However, when it came to business, according to Joe, Moe was on the ball. He had a knack for spotting problems, solving them quickly and multi-tasking with timely efficiency his many areas of responsibility. He was the perfect business partner.

Let's look back to the late 60s when the brothers started a business, Little Co., in a two-car rented garage. They struggled in the beginning. Yet, slowly but surely the business grew in sales and profitability. Market share and profits increased almost every year. By any standards Joe and Moe were a success, and they were rich.

From the very beginning Joe insisted on a buy/sell agreement for Little Co., funded by life insurance. At Joe's insistence, the stock was valued every year and additional insurance acquired to fund the increased value of Little Co.

Way to go, Joe! His buy/sell agreement insistence ultimately saves the day (you'll love this story). But first, a few more facts are needed, mostly about Moe, to set the scene for his train-wreck tax disaster for his failure to put a comprehensive estate plan in place.

Moe had five kids, two of them, Sid and Sam, worked for Little Co. Sid and Sam were chips off the old block and good at business. Joe and Moe often talked about how the two boys would ultimately own and run Little Co. Joe has three kids, but none of them ever worked for Little Co. or showed any interest in doing so.

Although Joe and Moe took exactly the same salary and enjoyed equal distributions from the large profits of Little Co. (an S corporation), 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, leaving everything he owned to his wife Molly. From time to time Moe would talk about doing a comprehensive estate plan (like Joe's), including transferring his share of Little Co. to Sid and Sam. Too bad, but Moe died suddenly two weeks before his 79th birthday. Procrastination and the IRS were the clear victors.

Of course, the buy/sell agreement kicked in. According to the agreement, Little Co. had a value of $23 million … $11.5 million for Moe's 50% 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.

Moe's widow, Molly (age 76), was now worth $26.5 million. No estate tax due now 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, like Joe and his wife did, would have yielded millions of dollars of estate tax-free insurance for Moe.

Joe now owned 100% of Little Co. Sid and Sam were ready to take over running the company, but they owned no stock. Uncle Joe, as always, wanted to do the right thing. So, after consulting with me, he sold half (50%) of his Little Co. stock to an intentionally defective trust (IDT) for $11.5 million and made the beneficiaries of the trust his nephews: Sam and Sid.

Under the tax law rules, the $11.5 million plus interest to be collected by Uncle Joe from the IDT will be tax-free: no income tax, no 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 finally done (Uncle Joe paid and the stock distributed to Sam and Sid) Moe’s sons will own 50% of Little Co. (25% each) and Uncle Joe will own the other 50%, just the way Moe wanted it.

The buy/sell agreement was updated, with appropriate language, to accommodate all possibilities — basically 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 would then own 100% of Little Co. Since Joe is still insurable, additional life insurance was acquired to cover the then fair market value of Little Co.

It should be pointed out that every detail of the plans for Joe, Sam and Sid (before and after Moe’s death) is not included in this article. The two most important points to take away from this article: No. 1 — Have a comprehensive estate plan like brother Joe, and the IRS will not become a partner sharing in your family's wealth. No. 2 — Failure to keep your estate plan updated, as required, guarantees the IRS a big pay day when you die.

Want to learn more about how to do your estate plan right? Browse my website at: www.taxsecretsofthewealthy.com. There's a mountain of free information there. You can also call me (Irv) at 847-674-5295.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail mailto:[email protected], or on the Web at WWW.TAXSECRETSOFTHEWEALTHY.COM.