What is the Estate Tax Trap High Net Worth Individuals Fall into?

How not to become a victim.

If your net worth is high enough to be subject to the evil estate tax, chances are you worked your tail off all or most of your adult life to accumulate your wealth… But draw your last breath and the estate tax monster wants to devour about half your wealth. Not a pretty picture.

It’s sad. Worse yet, the complete failure of almost all professional estate tax advisors to take you, your family and your business out of the horrible estate tax picture. Die and your estate pays… But fortunately, you – with the right tax planning – don’t have to lose any of your wealth to the estate tax monster.

Do you have enough wealth to be clobbered by the estate tax?… Then read every word of this article. You’ll learn how to keep your wealth. But first I must ask you to open your mind, because we are about to kill some sacred cows (really conventional wisdom of how almost all estate planning advisors, inadvertently, make you a victim of the estate tax.)

What exactly are these advisors guilty of doing?… Traditional estate planning.

Note: What is “traditional estate planning” (TEP)? A TEP is the plan that most advisors use for a married couple. Chances are if your estate plan is done, you have a TEP (and that’s good). A TEP uses a rather 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 now in the trust, which contains your estate plan. The trust is commonly called an “A/B trust” or “family /residuary trust” or something similar.

Is there anything wrong with a TEP?… absolutely not, assuming it is properly drawn.

Then what’s the problem?… The TEP is normally the only plan, and a 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: (1) the marital deduction defers any estate tax until the second death of the husband and wife (but when the second one dies, the IRS gets its pound of flesh); and (2) the so called “unified credit” (in 2009 was $3.5 million per person that passed free of the estate tax or $7 million for a married couple; the exact amount at this writing – early January, 2010 – is unknown until Congress acts.)
Let’s summarize: If the unified credit continues at $3.5 million (or whatever Congress finally blesses us with as estate tax free), the best a TEP can do – as far as saving you estate tax – is to save you 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 even a dime in taxes, over and above the unified credit is a myth, hoax and total illusion. If your estate plan consists of a TEP and only a TEP (or even 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 in the document that the savings are created.

Yes, the above are tough accusations. Some of the accused will come after my scalp. But most will read what follows and improve the way they do estate planning. How do I know?… Two reasons:

1. Over the years I have talked to dozens of estate planning advisors after their clients asked me to review their estate plans…. I am only talking about those plans that used only a TEP (or on occasion added an ILIT).  In every case, except two, the advisor welcomed my input and supported the suggested additions to the client’s estate plan.
2. Now reason #2: For 22 years (starting in the 80s) my assistant scheduled from 18 to 24 estate planning seminars from coast to coast (mostly trade association meetings). Every year 3 to 5 of those seminars were given to “estate planning councils” (EPC) (attended by experts in estate planning and primarily lawyers, CPAs, financial advisors and bank trust officers). I always challenged each EPC audience to list the ways a TEP saved estate taxes. Never, but never, could any of those audiences add to the two tax tricks described above.  Then, I would spend about 2½ hours teaching my estate planning system (some of which follows in brief) to my want-to-learn audiences.

My motivation for this article was and is the following email received from a reader (Joe) of my column, “I am working with a law firm… designing a will and trust [a TEP] and would like you to review the documents.” After a few questions, I agreed to review the documents if Joe would send along three items: two financial statements (a personal one and his last year-end for his business, Success Co.) and a family tree (name and birthday for Joe, his wife and four kids).

Three days later Joe’s information package arrived. Here’s a few things you should know about the information in the package.

• A typical TEP was the entire estate plan.
• The lawyer (Larry) who drafted the TEP (it was very well done) boasted on his stationery that he is “a Board Certified Specialist in Estate Planning, Trust and Probate Law.”
• Joe (48 years old) owns Success Co. (an S corporation) that he started from scratch, is very profitable and growing. Joe likes Larry professionally, but feels that somehow the plan Larry created falls short of accomplishing Joe’s goals.

Without going into great detail this is what we (not only me, but my network of experts) advised Joe to do:

• Retain Larry and sign his documents, after one suggested change.
• Since the TEP does not legally speak until Joe dies (when that will be is uncertain, but according to the life expectancy tables, about 35 years) a lifetime tax plan should be created.

So, simply put, everyone should have two plans: a death plan (TEP) and a lifetime plan. The purpose of the lifetime plan (an example follows) is to take such 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.

Also remember that Joe, like the typical guy, wants to control his wealth – particularly his business – to the day he dies.  Here’s the list of 10 Strategies (actually there are more) we wove into a comprehensive lifetime plan for Joe, his family and his business:

• Asset protection strategies to protect Joe’s personal assets and, separately, the business assets.
• A management corporation (a C corporation) was set up to provide Joe (but not other employees of Success Co.) with many tax-free fringe benefits (including long-term care and deductibility of all – Joe, his wife and four kids – medical expenses).
• A family limited partnership for Joe’s investment assets.
• A non-qualified deferred compensation plan for his two key employees (an easy way to prevents employees from leaving and competing with you).
• 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, yet 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.
• A strategy to save income taxes whenever a new unit of Success Co. is opened.
• How to make the insurance on Joe’s life estate tax-free and buy over $3 million of second-to-die life insurance using the government’s money.

And finally, a question clients always ask, “Irv, how do I know when my estate plan is done and done right?”… Here’s a two-point answer: (1) When your advisor can look you in the eye and tell you – whether you are worth $5 million or $50 million (or more) – that the estate plan created for you will eliminate the impact of the estate tax. Simply put, if you are worth $11 million, $11 million to your family (all taxes paid in full), if worth $44 million, $44 million to your family. Fill in your own number. And (2) the advisor can explain in simple English how each strategy works to save those millions.

Irv Blackman is an experienced CPA and lawyer who specializes in estate planning, business succession and asset protection.. He is the founding partner of Blackman & Kallick, the largest independent CPA firm in Illinois. He is the founding Chairman of the Board of New Century Bank, Chicago visit his website www.taxsecretsofthewealthy.com.