Live like a King; just don’t die like a Prince

It turns out that pop icon “the artist formerly known as Prince” may have died without a will and over half of his net worth will be confiscated by the government. The problem is that the IRS puts an estate tax box around everything we own and we need to provide an inventory on the final tax return that will be filed on our behalf after we die, the dreaded form 706.

In Prince’s case his estimated net worth of up to $500M could end up generating a windfall for the IRS and state of Minnesota of over $250M in taxes. This cost could be even greater when you consider the cost to liquidate assets to pay the IRS in 9 months. It is unlikely Prince kept $250M siting in the bank and the IRS wants to be paid in cash not little red corvette’s

The financial tragedy is that with proper planning estate taxes can be voluntary for most of us and even if we are living like a King with the net worth of a $500M rock star; the taxes can be deeply discounted by just using the tools the government provides us and some creativity.

Everything we own is trapped in our estate tax box. We pay tax to government when we earn the income, pay sales taxes when we buy things, property tax on many of the things we buy like real estate, cars and boats, taxes on our investments as they grow, and then the IRS puts up a large toll gate between you and your children and even another toll between you and your grandchildren.

Fortunately, if we are married when we die the IRS allows us to pass 100% of what we own to our spouse. But those assets plus what our spouse owns will be subject to an estate tax after both you and your spouse die and divided between the government and your kids and other heirs.

Some of the goals of estate planning are:

  • To keep everything, you buy or accumulate outside your estate tax box.
  • Transfer assets inside the box outside the estate tax box.

To accomplish these goals, we use gift exemption that the IRS allows us to drill holes in the estate tax box and use creative strategies to leverage the value of these transfers so we can generate (5 to 1), (10 to 1) or even (20 to 1) value of the precious cargo of gift allowance.

To start with you can give assets away to your loved ones, we can gift $14,000 per year to anyone. This is a use it our lose it annual gift allowance and by husband and wife combining their gift capacity they can gift $28,000 per year, over time with growth this can accumulate to a significant amount that will escape taxes. Beyond the annual gift we all have a lifetime gift exemption currently $5,450,000. If you exceed these limits during your lifetime you need to pay a gift tax. We can give this away while we are alive or this is the amount that will transfer tax-free to our heirs at death.

The value of gifting this during lifetime is that your heirs benefit from the gift plus future growth. By using a trust with a fancy name called IDGT (Intentionally Defective Grantor Trust) it is like a trust on steroids, you can give assets away using your exclusion and lifetime exemption and retain the responsibility to pay the income taxes due each year on the growth of the trust. In effect becomes and additional gift tax-free transfer each year which makes the holes in the estate tax box bigger.

This enables you to give away the asset, growth on the asset and the taxes due on the growth.

It is clear that you can pay less in taxes and give away more to your heirs by planning and gifting in advance but we find that clients are reluctant to do so because they don’t want to give up control of the asset and they worry about what will happen if they end up needing the money in the future. This is where creativity comes in and for many of our we reach into the tool box to freeze discount and leverage the value of the gifting capacity the IRS allows while providing the ability to maintain control and have a back door to the assets if they are ever needed.

This involves two-part solution:

FLLC (Family Limited Liability Company)

Step one is to set up a Family LLC and transfer assets you believe are going to accumulate into the LLC. The LLC can be split between manager interest and economic interest. So you can retain the managing interest in the LLC, you’re the CEO and have 100% control on the LLC and all the assets. We can then gift the economic interest of the LLC to a trust for the benefit of your heirs. This gift can count against your annual exclusion and lifetime exemption. But there is another advantage, since you are gifting LLC interest that are not liquid and have no voting rights, you can take a discount for lack of Market ability and control so it may be possible to transfer almost $8M of assets for using your $5.4M exemption.

Another option that can provide even greater leverage is to sell the LLC interest to the trust, and take advantage of the low-interest rates called AFR of 2.24% for 30 years.

In this example $20M of LLC value is sold to the defective trust. At a 6% investment rate the value in 30 years grows to almost $80M, and the $20M note is repaid and we were able to transfer $64M of value outside the estate tax box.

Installment Sale of $20M LLC value to a IDGT
Terms: Interest only 2.24 AFR, 30 years Balloon Note
Assumption 6% ROR, defective trust grantor pays income tax, 100% of earnings accumulate.

The FLLC allows for total control over the asset, and the defective trust provides that added transfer benefit of paying taxes on behalf of the trust growth, but what if the parents need the money. Part of the solution is the sale vs. an outright gift, in this example the $20M note can be called at any time so this can be a payment back to the grantor from year 1 to finally in year 30.

The other part of the solution is a SLAT (Spousal Lifetime Access Trust).

You as the grantor can make your spouse a beneficiary of the trust and allow her to have access to all the income the trust earns, and even the principal if he or she needs it. You can even set up a line of credit between the trust and your spouse in the even that there is a temporary cache need, the key is you can provide back door access to this asset and if you do not need the funds then it all will pass to your heirs as beneficiaries outside the estate tax box. The trust provisions can protect your spouse, children and even grandchildren and allow you to keep assets in the family in the event of a divorce or other adverse circumstances.

Suppose that you are able to freeze discount and leverage and transfer a significant portion of your estate outside your estate tax box, but not all and you still would have to pay estate taxes.

The solution could be to use life insurance as an asset class to be able discount the cost of the estate tax bill or provide the liquidity. You can set up an insurance trust called and ILIT, and rather than have you or your spouse own the policy and have the life insurance come back into the estate tax box it gets paid to the trust. Your spouse can be the beneficiary of the trust and receive income and principal while alive but afterwards 100% pass for the benefit of your heirs and can provide the funds need for payment of taxes. If there are no taxes, then the insurance is a tax-free death benefit to the trust that is available for your heirs. Do you think the Prince’s family would have an interest in a $250M life insurance trust about now?

Since insurance is not free, and the premiums for a trust owned policy are considered gifts that count against your annual exclusion and lifetime gift exemption, we can use a concept called Split $ and parents or if you own a business, your Corporation can lend the premiums to the trust and significantly reduce the gift impact of the premiums.

The estate planning tool kit is a lot like my neighbor who as the ultimate man cave in his garage, no matter what I need, he has the right tool, from a simple repair to building an addition on my house, Steve has it. Based upon our experience of working with very sophisticated and complex estates the past 25 years, at M3 we feel we have the ultimate estate planning man cave, beyond FLLCs. IDGT’s and SLAT’s it contains, GRATS, Self-canceling notes, Cash settled options, Charitable Trusts and Split $ with an ILIT. More important than the tools, is the vision, your goals and objectives for your life and your children. This leads to the design of the plan and the use of the tools and planning that will allow you to preserve and protect your wealth from the estate tax box.

This message is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell any securities or related financial instruments. M3 Wealth Advisors, LLC (M3) is not responsible for any recommendation, solicitation, offer or agreement or any information about any transaction, customer account or account activity that may be attached to or contained in this communication. M3 accepts no liability for any content contained in the email, or any errors or omissions arising as a result of e-mail transmission. Any opinions contained in this email constitute the sender’s best judgment at this time and are subject to change without notice.  Realized performance is presented as an estimation.  For the most accurate account details please see your monthly statements.