Joe’s estate plan crashes and burns

Although Joe was a planner, after he went to the big business in the sky, his estate plan and business succession plan (for Success Co.) turned into an economic and tax tragedy. For his son, Sam. For his wife, Mary. And the rest of the family.

Sadly, I regularly get calls with the same or similar facts, always followed by painful and costly results. So, read every word. Chances are you'll be saying, “I’m Joe,” more than once.

Here are Joe’s facts before he died.

Joe and Mary have three kids: Sam who helps run Success Co. and two adult non-business kids. The three core goals Joe and Mary told their advisors (their lawyer and CPA) were: 1) Sam should ultimately own 100% of Success Co.; 2) treat the three kids equally; and 3) pay as little as possible in taxes to the IRS.

Joe’s advisors completed the planning in early January 2005. As part of the plan, Success Co. (an S corporation) was sold to Sam for $12 million (its fair market value). Sam paid his dad in full with a $12 million note, to be paid in semi-annual installments over 10 years, plus 4.5 percent interest on the unpaid balance.

In January 2005, immediately before the sale of Success Co., Joe’s assets, including Success Co., totaled $27.7 million.

Now, substitute your own numbers. Then follow the solutions later in the article. You’ll strike tax gold.

Joe's lawyer created a traditional estate plan with an A/B trust. Since Joe and Mary had a $2 million second-to-die policy (and $9.1 million in liquid assets, plus the future cash from the $12 million note, from the sale of Success Co.), the professionals figured there was plenty of liquidity to pay estate taxes. They agreed that no additional planning was necessary. Note: Both Joe and Mary were healthy in 2005.

Now here comes the horror story.

Joe died suddenly of a heart attack in 2007. What is the economic and tax impact of Joe’s death on his family members?

For the entire $12 million, Sam’s earnings must be over $20 million for the family to receive $6.6 million. Lousy tax planning.

What happens to Sam

Sam’s situation is a disaster from the day the Success Co. sale papers were signed. (Problem #1) The price. The $12 million value for Success Co. was fine; it was based on a professional appraisal. But the $12 million price, as between father and son, is wrong. Why?

The IRS allows a 35 percent discount — for lack of marketability — for nonpublic businesses like Success Co. So, for tax purposes, the right price should have been $8 million (rounded), reducing Joe’s taxable estate by $4 million.

(Problem #2) Difficulty in paying the price. For ease of explanation, let’s say the price is $1 million. How much does Sam have to earn to pay that $1 million? Would you believe $1.7 million? The amount, which includes Federal tax, varies depending on the income tax rate of the buyer’s home state. Sam lives in a high-tax rate state — over 7 percent. Result: Sam must pay $700,000 in taxes, Federal and State, to have $1 million left to pay his dad.

Apply the $1 million example to Sam’s situation. He must pay over $8.4 million (12 x $700,000) in taxes to pay off the $12 million note. Simply put, Sam must earn in excess of $20 million, before taxes, to pay off the note. Plus interest. Outrageous!

Mary’s situation

Fortunately, the 100% marital deduction spared Joe’s estate from any tax due at his death. But the entire family, especially Mary, was in a state of shock when their lawyer told them the loss to estate taxes would be in the $10 million range when Mary died.

The final blow: As explained above, Sam must earn $1.7 million, pay $700,000 income tax (State and Federal) to have $1 million to pay down the note. Joe is socked with a capital gains tax. Only $850,000 left. Estate tax on the $850,000 in Mary’s estate (when she dies) will be about $300,000. Only $550,000 remains. The full lost-to-taxes picture: for each $1 million of the note, Sam must earn $1.7 million for the family to wind up with only $550,000. Unbelievable!

For the entire $12 million, Sam’s earnings must be over $20 million for the family to receive $6.6 million. Lousy tax planning.

The two nonbusiness kids

They were forgotten in the plan, until Mary died.

Here’s what Joe and Mary should have done.      

Lack of room prevents me from covering every point, issue and possibility. But the following are the most important strategies that would have allowed all of Joe’s $27.5 million to go to his family, all taxes paid in full.

1)   An intentionally defective trust (IDT). First, a recapitalization of Success Co. (100 shares of voting stock, kept by Joe, and 10,000 shares of nonvoting stock to be sold to the IDT). The discount is 40 percent, resulting in a price to Sam of only $7.2 million. The entire transaction is tax-free to Joe: no capital gains tax, no income tax on interest received.

What’s the cost to Sam? Zero! Not one penny. Profits (really future cash flow) of Success Co. will pay the $7.2 million note.

2)   Life insurance. Since Joe and Mary were insurable in 2005, we would have bought about $11 million (set up to be free of all taxes) in second-to-die life insurance. Note: My insurance consultant said the premiums would be about $10,500 per $1 million.

3)   Family limited partnership (FLIP). The “investment” assets total $12.1 million, but only $11 million would be transferred to a FLIP. The IRS allows a 35% discount making the FLIP assets worth only $7.15 million for tax purposes.

4)   Gifting program. Joe and Mary have eight grandkids, so all together with the three kids we have 11 noses. The maximum tax-free gift was $11,000 in 2005. So, Joe and Mary together could make a $22,000 gift to each nose or a total of $242,000 per year.

Every strategy listed above is easy to do and, when done right, accepted by the IRS. Just how can you protect yourself, your business and your family from becoming a victim like Joe, Mary and Sam?

Here’s how: When your professionals are done with your estate plan (include your succession plan), ask them to show you how the plan passes all of your wealth — intact — to your heirs. For example, if you are worth $5 million the entire $5 million will go to your heirs, all taxes, if any, paid in full. If $50 million, the entire $50 million. Just substitute your own numbers. What if 100 percent of your wealth is not passed intact? Get a second opinion!

Want to learn move about this fascinating subject? Browse my website, www.taxsecretsofthewealthy.com. Or call me (Irv) at 847/767-5296 or email me at [email protected].

Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick LLP and chairman emeritus of the New Century Bank, Chicago. He can be reached at 847/767-5296, email [email protected] or on the web at www.TaxSecretsOfTheWealthy.com.