Some professional advisors fail to take you, your family and your business out of the horrible estate tax picture. Die, and your estate pays. Fortunately, with the right tax planning, you don't have to lose any of your wealth to the estate tax monster.
Traditional estate planning (TEP), uses a simple will, called a "pour-over will" and an irrevocable trust. The will gathers any assets not in the trust when you die and pours these assets into the trust. All your assets are then in the trust, which contains your estate plan. The trust is commonly called an "A/B trust," "family/residuary trust" or something similar.
Assuming the TEP is properly drawn, nothing is wrong with it. However, it shouldn't be your only plan. The TEP is not designed to save estate taxes. If you are married, it does many other things, which makes a TEP a good start for your estate plan.
A TEP does have two minor estate tax tricks: First, the marital deduction defers any estate tax until the death of the last surviving person in the marriage (but when this person dies, the IRS gets its pound of flesh). The second trick is the so-called "unified credit," which in 2009 allowed $3.5 million per person (or $7 million for a married couple) to pass estate-tax-free.
So if the unified credit continues at $3.5 million, the best a TEP can do is to save you estate tax on the $3.5 million for the first spouse who dies. That's it.
It's difficult for me to say what follows: Any claim that a TEP can save you more than the unified credit is a myth, hoax and total illusion. If your estate plan consists of a TEP alone, or even if it includes an irrevocable life insurance trust (ILIT), chances are you've been duped. If your advisor claims otherwise, challenge him or her to show you where and how the savings are created in the document.
This leads me to an example of Joe, a 48-year-old-reader of my column who asked me to review the documents for a will and trust he was working on with a law firm. Joe owns Success Co., an S corporation that he started from scratch. After reviewing two financial statements (personal and business) and a family tree, I discovered that a typical TEP was used as the entire estate plan.
Even though Joe liked the lawyer who drafted his will and trust, he felt that somehow the plan fell short of accomplishing his goals. So, we (my network of experts and myself) advised Joe to retain his lawyer and sign his documents after one suggested change. Also, because the TEP does not legally speak until Joe dies, Joe needed to create a lifetime tax plan.
Simply put, everyone should have two plans: a death plan (TEP) and a lifetime plan. The purpose of the lifetime plan is to take actions and employ various strategies so that by the time you go to the big business in the sky, the estate tax has been eliminated or you have created enough tax-free wealth that any estate tax liability is covered. Remember, it's not what you are worth today that's socked with the estate tax, but the amount you (or your spouse) will be worth after both of you have entered the pearly gates.
Here's the list of 10 strategies we wove into a comprehensive lifetime plan for Joe, his family and his business:
- Protect Joe's personal assets and the business assets independently using various asset protection strategies.
- Set up a management corporation (a C corporation) to provide many tax-free fringe benefits (including long-term care and deductible medical expenses) for Joe and his family.
- Create a family limited partnership for Joe's investment assets.
- Create a non-qualified deferred compensation plan for his two key employees.
- Use a common paymaster to save significant amounts of payroll taxes every year.
- Create a plan to use a portion of the profits of Success Co. to pay for the children's college education.
- Transfer Success Co. to the children tax-free, while Joe maintains control.
- Set up a family foundation and a charitable lead trust as a tax-effective way to make substantial charitable contributions without reducing the children's inheritance.
- Devise a strategy to save income taxes whenever a new unit of Success Co. is opened.
- Make the insurance on Joe's life estate-tax-free and buy more than $3 million of second-to-die life insurance using the government's money.
So, how do you know when your estate plan is complete and correct? When your advisor can look you in the eye and tell you that the plan will eliminate the impact of the estate tax. Also, when your advisor can explain in simple English how each strategy works to save those millions.