Legally eliminating the estate tax might sound impossible, but if you know the right tax rules and how to organize those rules for your specific situation, you can achieve this goal.
Consider Joe, age 62, who started Success Co. 34 years ago. He now has two significant sources of income: Success Co. and the various other assets he has accumulated. Joe’s after-tax income far exceeds the money he and his wife, Mary, also 62, need to maintain their comfortable lifestyle. Unfortunately, every additional $1 million he earns will feed $400,000 to the estate tax monster. Without a comprehensive estate plan, time favors the IRS.
A comprehensive estate plan is designed to deliver every dollar of your wealth on the day you die—all taxes paid in full— to your heirs. No two estate plans are ever exactly the same, but there are certain core principles and strategies that can be used to virtually eliminate the estate tax. Each significantly reduces the potential tax burden and enables the asset owner to maintain control of it, if he or she so desires. Three basic strategies are:
These include the $5.25-million one-time exemption ($10.5 million, if married) we discussed in
this column last month. It should be used as soon as possible, especially for assets likely to increase in value or throw off a large rate of return. Another such gifting program is the annual $14,000
exclusion ($28,000, if married) that enables you to donate that amount to each of your heirs every year.
Discounts of assets for tax purposes
This amounts to a 40-percent discount in the value of a business like Success Co. For example, a $20 million business is only valued at $12 million for tax purposes. Two key strategies for taking advantage of this discount are:
1. Intentionally defective trust (IDT). Joe creates an IDT and sells Success Co. to it with his son, Sam, named as the beneficiary. The entire transaction is tax-free, and the company is out of Joe’s estate. Joe also can gift as much as $17.5 million (before discounts) to the IDT tax-free.
2. Spousal access trust (SAT). Creating such a trust would enable Joe to continue to receive income from Success Co. while eliminating as much as $10.5 million out of his estate. To do so, he would gift $17.5 million in company stock to Sam tax-free. With the 40-percent discount, this amounts to a $10.5-million one-time exemption.
A 35-percent discount also is allowed for investment-type assets such as stocks, bonds, CDs, real estate, interests in partnerships and similar assets. The key strategy for capitalizing on this discount is transferring such assets tax-free into a family limited partnership (FLIP). Then the FLIP interests can be gifted to your heirs.
Funds in a qualified plan
Qualified funds, which include 401(k)s, IRAs or the like, normally are double taxed, both
with income and estate taxes. So for $1 million in funds, $730,000 goes to the IRS and only $270,000 to your family. The key strategy here is to use a “retirement plan rescue” to turn these double-taxed dollars into tax-free dollars.
All the strategies outlined here should be your weapons of choice to kill the estate tax monster if you are worth about $18 million or less. But what if you are worth more? You should still take full advantage of the opportunities they offer, no matter how large your estate is today or is likely to become. However, if your estate is worth more than $18 million, you must get your wealth into a tax-free environment and keep it there until your death to really wipe out the estate tax.
For estate-tax purposes there are only two tax-free environments: life insurance and charitable donations. In fact, if you are charitably inclined, it is a cinch to beat the estate tax. But let’s assume you want all your wealth to go to your heirs and to charity only if it does not reduce the amount your heirs will receive. Insurance can be a super tax and economic weapon for the mega-wealthy if you and/or your spouse are insurable.
The cost of life insurance and its death benefits are influenced by your age, health, market conditions and other factors. Joe and Mary purchase a $10 million second-to-die policy with an annual premium of $125,000. If they live another 32 years, that premium cost will total $4 million, but that $4 million cannot be plundered by the estate tax. So, in the end, Joe and Mary really will have contributed $2.4 million and the IRS $1.6 million—the 40 percent saved in estate taxes. The overall tax and economic result is that we’ve turned $2.4 million into $10 million tax-free.
Note: In most cases when such large insurance policies are purchased (those with about $100,000 or more in annual premiums), the client does not pay the premiums out of pocket but instead uses “premium financing” in the form of a bank loan to pay them.
If you are not “insurable” for some reason, a host of charitable strategies can enable you
to enrich your favorite charity without reducing your family’s inheritance. You should review all the possibilities as part of your comprehensive plan.