ItÕs amazing. Most successful family business owners toil their entire lives to build the business and the familyÕs wealth. Yet the day they die is a big payday for the IRS. Far too many business families overpay their estate tax. They give away money they could have kept had they made changes in their estate plans.
Often my firm is contacted by family business owners who want a second opinion on their estate plans. After many reviews, we have found 10 common and expensive estate planning myths, misconceptions, and mistakes about estate planning that seem to be repeated over and over. Here they are. Try to avoid them.
1. Myth: A revocable living trust can save taxes. Some lawyers, but more often nonlawyers, make a lot of money promoting living trusts (often called Òloving trustsÓ) as the key to estate planning. I like these trusts and often recommend them. Putting all your property in a living trust will avoid probate. A living trust can also help avoid long and messy court proceedings if you should become disabled.
But a revocable living trust can never avoid either income or estate taxes. During your life, you will be taxed on all income earned by the trust as though you owned the property directly, and all property titled in the name of the trust will be included in your estate.
There is also a common mistake: Many people, after executing a living trust, neglect to take the next stepÑtransferring legal title of their assets to the trust. As a result, the living trust is a worthless stack of papers. The rule is simple: Assets held in your name will be included in your probate estate.
2. Myth: You will lose control of your corporation if you transfer more than 50 percent of it to your children. There is no reason a transfer in ownership must mean a transfer in control. There is a simple two-step process to follow. First, recapitalize your corporation so you have voting stock (say, 1,000 shares) and nonvoting stock (say, 99,000 shares). This is a tax-free maneuver. It works for both a C corporation and an S corporation. Second, start transferring the nonvoting stock to your kids via outright gifts, the use of grantor retained annuity trusts, employee stock bonuses, and other means. You can give away all the nonvoting stockÑalmost the entire tax value of your business; yet by keeping the 1,000 shares of voting stock you retain absolute control for as long as you live. You save three ways: income tax, gift tax, and estate tax. Plus, the future growth of the business is removed from your estate.
3. Myth: There is an advantage to holding assets jointly. Joint tenancy is often called the poor manÕs will. Many husbands and wives hold assets jointly. For tax purposes, those assets will pass free of estate tax to a surviving spouse. However, holding everything jointly will have the same effect as leaving everything to the other spouse. The opportunity for the first spouse who dies to leave $600,000 of assets to children tax free will be lost.
Also, when you die, the basis of property you own is raised to its value at the date of death for income tax purposes. For example, say Joe and Mary own in joint tenancy all the stock of Success Co., which is worth $1 million but only has an income tax basis of $100,000. Joe dies. Mary now owns 100 percent of Success Co. WhatÕs her tax basis? Only $550,000Ñ$500,000 for the half she inherited from Joe and $50,000 for the half Mary owned as a joint tenant. If Joe had owned the stock and left it all to Mary, her new tax basis would have been $1 million. As a joint tenant, if Mary sells the stock for $1 million, she must pay tax on $450,000 profit instead of zero. Some difference!
4. Misconception: Leaving everything to your spouse avoids the estate tax. All the words following ÒmisconceptionÓ are true. However, many people who blindly think this way fail to make good use of common tax credits.
•The marital deduction allows you to avoid estate tax at your death for all assets that you leave to your spouse. The unified credit shelters up to $600,000 of assets from estate and gift tax. But failing to use the unified credit during your lifetime usually ends up costing your family more in estate taxes.
•Suppose you are worth exactly $1.2 million. You leave it all to your wife, Sue. So far so good. When you die, there is no tax because of the marital deduction. Next, assume Sue dies with the same $1.2 million 15 years later; she lived off the income. The first $600,000 of SueÕs estate is tax free (the unified credit). The balance ($600,000) will trigger an estate tax of $235,000. Had you been smart enough to set aside the first $600,000 in a so-called credit shelter trust, you would have blown the marital deductionÑa good move because the unified credit shelters the $600,000 trust from any tax. Now, when Sue dies, her estate is worth only $600,000. WhatÕs her tax? Zero.
5. Misconception: Life insurance will transfer wealth to your heirs free of the estate tax. HereÕs the law: Owning insurance policies on your life and designating the beneficiaries means the proceeds will be taxed in your estate. Even if you leave the proceeds to your spouse or if your spouse owns the policies, the proceeds will be taxed in the second spouseÕs estate.
Can the tax be avoided? Absolutely. Just set up an irrevocable life insurance trust (ILIT), leaving the insurance proceeds to the trust. Then, your spouse gets the income for life. At his or her death, the balance in the trust goes tax-free to your children or grandchildren.
An ILIT can save your family up to $55,000 for every $100,000 in life insurance. An ILIT is one of the best tax-saving tricks available in the entire tax law.
6. Misconception: Since the gift tax rates and the estate tax rates are the same, you may as well keep your property and let your kids inherit it. True, the gift tax and estate tax use the same table. But because of a quirk in the law, gift taxes are a bargain. For example, suppose you are in a 50 percent gift tax bracket (you have made many large gifts during your lifetime) and will be in a 50 percent estate tax bracket. A gift of $100,000 to each of your two children ($200,000 total) will cost you $100,000 in gift taxes. The final bill (gifts plus tax) is $300,000. But if you want to leave the same net amount to your two kids after you die, you will need $400,000 in your estate. It will be taxed at 50 percent, leaving $200,000 for the two kids.
7. Mistake: Not understanding what your estate will be worth. Whatever you own on the day you go to the big business in the sky is included in your taxable estate. ThatÕs the easy part. The mistake is forgetting that you arenÕt dead yet. Many people fail to consider a number of items that will increase the value of their estate over time: life insurance proceeds, inheritances, inflation, and increases in the intrinsic value of certain assetsÑparticularly the business and real estate. These items will result in greater tax, unless they are offset by tax-saving techniques put in place while you are alive. For example, life insurance proceeds can be countered with irrevocable lif -insurance trusts; inheritances with skip-a-generation trusts; inflation with gifts; intrinsic-value increases with grantor retained annuity trusts; and family limited partnerships.
8. Mistake: Not considering the generation skipping tax (GST). The GST is a 55 percent flat tax imposed in addition to the regular estate tax, which also reaches 55 percent over $2.5 million. The purpose of the GST is to guarantee that grandchildren receive their inheritance only after the assets have been taxed twice; once, as if the assets had gone from the grandparent to the parent, and a second time as if the assets had gone from the parent to the child. Ouch!
But take heart. There is a $1 million exemption. Only the excess is subject to the GST. For example, when Joe, a grandparent, leaves $1 million to his children (assume he and his children are in a 55 percent estate tax bracket), JoeÕs grandchildren receive just $450,000 because of the estate tax imposed on the childrenÕs estates. But if the money is left in trust for the life of JoeÕs children, no taxes (estate or GST) are owed when the children die and it passes to the grandchildren, because of the $1 million GST exemption. JoeÕs family saves $550,000 in estate tax. WhatÕs more, JoeÕs wife can pull off the same trick and double the familyÕs tax-saving pleasure to $1.1 million.
9. Mistake: If you are in a high income and estate tax bracket, leave large sums in a qualified pension plan or IRA. Funds in a qualified plan or IRA will be taxed at least twice after you dieÑonce for income taxes and a second time for estate taxes. A third tax for large accumulationsÑa 15 percent excise taxÑis also possible. Typically, the tax burden for a high-bracket taxpayer is at least 70 percent, and it can go to over 90 percent depending on your state taxes. Your family will be shocked: $1 million in a qualified plan will turn into only $300,000 or less for your heirs.
What to do? Take an annuity from the plan to fund a life insurance policy (on your life or a second-to-die policy with your spouse) owned by an irrevocable trust. It will beat every cent of your tax liability. This technique can even create tax-free wealth, beyond the amount in the plan.
10. Big myth, misconception, and mistake: The estate tax laws rarely change, so you donÕt have to review your estate plan. Wrong! Congress and the IRS are always making changes in the estate tax law. And even if they did leave the rules alone, review is a must every year or so. Inflation, real growth, or both, will increase the value of your assets and raise your estate tax liability. Changes in family circumstances, such as marriage, divorce, or new grandchildren will require new estate tax strategies. So will changes in state law. Finally, tax consultants try to keep as busy as the IRSÑonly theyÕre looking for new tax-saving techniques. As techniques are discovered, you should make the best use of them.
Irving L. Blackman is a founding partner of Blackman Kallick Bartelstein, a CPA firm in Chicago. The firm offers three special reports: Pay Zero Estate Tax The Super Trust Way; How to Triple Your Pension, Profit Sharing, or IRA Value; and How You Can Beat the Estate Tax Legally ($25 each, $57 for all three). Contact Blackman Kallick Bartelstein, 300 South Riverside Plaza, Chicago, IL 60606. (Cartoon from Someday ItÕll All be WhoÕs?, published by the Center for Family Business in Cleveland, OH.)