A question I am regularly asked in my practice is whether it is possible to reduce or delay payment of capital gains taxes on the sale of real estate without having to undertake an Exchange under IRS Code Section 1031. The answer is yes, and you may be able to defer payment of the capital gains tax on the sale of other assets as well, such as the sale of your business.

Under IRS Code Section 453, it is possible to defer the capital gains owed on the sale of an asset for up to 30 years, but some methods of implementing deferral are smarter (maybe something other than smarter? Don’t want to make them feel stupid) than others. In this writing, you will learn the smartest method currently available to taxpayers for the sale of both real estate and business stock – one that is sure to at least make you reconsider how you plan to sell a high gain parcel of real estate or a family business.

Scenario

Let us start by imagining an LLC made up of four partners located in Beverly Hills, CA is being sold for $20,000,000.00.  There is an interested buyer but the seller is concerned and possibly reluctant to sell due to the amount of capital gains that will come due as a result of the sale.  The lawyer and CPA are approached to develop a solution, for which the lawyer is familiar with the strategy that DKI uses. The cost basis of the company is $2,000,000.00 and there is an outstanding loan balance of $400,000.00.  The State of California’s tax rate is 13.30% and additional transfer tax is 0.11%.  The Federal tax rate is 23.80% so the seller’s total tax exposure is 37.21%.

The Lawyer covered the generalities with the seller and the CPA and then called DKI with additional questions.  DKI provided answers to the lawyer’s questions and then referred him/her to a third party law firm for expert advice.  The lawyer, expert legal counsel, the CPA, and the Seller discussed to options for which the seller came to the conclusion that this was the best option they could utilize to retain as much cash as possible. The comparative net proceeds from each method of sale is illustrated below:

What is an Installment Sale?

An installment sale is a method in which an asset can be sold for value, whereas the payment for asset occurs over an extended period of time.  This type of sale method functions under the Internal Revenue Code Section number 453.Tax code section (453) was drafted to specifically address installment sales and has been in effect since the establishment of the tax code in 1913.

The difference between the traditional installment sale and the installment sale illustrated above is that a monetized loan based on the principal amount is provided to the seller immediately after the sale. Under the traditional installment sale, the capital gains tax is not owed until principal under the financed sale is received. So, for example, if the installment sale involves payment of ten percent (10%) of the principal for ten (10) years, the seller would pay ten percent (10%) of the capital gains tax owed on the sale each year for ten (10) years; the tax is incurred as principal is received.

In a smartly executed installment sale, the seller does not have to wait for payment of the principal for thirty (30) years (or whatever the deferral period is) in order to defer the payment of the capital gains tax for thirty (30) years. The seller, by way of a monetized loan from a third party lender, is able to receive almost all of the principal on the sale immediately and still not have to pay the capital gains tax on the sale for up to thirty (30) years!!!

Steps & Purpose of Each Step

At the outset, authority for this transaction was provided on August 24^th, 2012, when the Internal Revenue Service via the Office of its Chief Counsel issued Memorandum #20123401F which, in substance although not quoted, approved tax deferral for an installment sale under Section 453, even in instances where the installment sale transaction was/is combined with a monetizing loan from a third party lender as described above. The steps of this transaction are as follows:

• The first step is Loan Underwriting: Initial transaction assessment, structuring, risk mitigation, advisor interfacing, and qualification for submission to a qualified Dealer (the “intermediary”). Estimated time for this process is two (2) Business Days;
• Installment Transaction: Once the Dealer decides to go forward based upon the aforementioned Underwriting, the Seller sells its asset to a qualified Dealer by virtue of an Installment Sale Contract (hereinafter referred to as the “Installment Contract”). The Installment Contract will provide payment of interest only to the Seller for thirty (30) years, with a balloon payment of the entire amount of principal to be paid from the Dealer to the Seller in year thirty (30). The Dealer will then sell the asset to the Buyer for a cash payment, and the Buyer will take ownership of the asset and is finished with their end of the transaction;
• Loan Transaction: Seller is then offered a loan from a financial institution based upon the value of the principal owed on the Installment Contract in Step 2, above. The terms of this loan are substantively identical to the Installment Contract; in other words, the Seller will pay interest at the same interest rate as that required in the Installment Contract, and will owe a balloon payment for the principal amount of the loan in year thirty (30) to the Lender. This part of the transaction occurs immediately post-sale between the Seller and the Third Party Lender; and
• Third Party Processor: The Seller utilizes a 3^rd Party Payment Processor (hereinafter referred to as the “Processor”) to collect all incoming interest income from the Dealer for the course of the thirty (30) year Installment Contract. The Processor will deposit the interest income into an account established on behalf of the Seller, and will then pay all outgoing interest expenses owed to the Lender for the course of the thirty (30) year loan from the same account.

The entire transaction is summarized in the schematics illustrated in the diagrams shown below:

Part 1: The Installment Sale Transaction: (Seller Sells to Dealer / Dealer Sells to Final

Part 2: The Independently Provided Loan Transaction: (Lender offers Loan to Seller)

Part 3: The Third Party Payment Processor: (Each party engages in escrow instructions)

The Entire Installment Sale Transaction:

(Seller Sells to Dealer / Dealer Sells to Final Buyer)

A Few Specifics

Firstly, installment contract sales are the oldest method to buy and sell assets in the United States. The installment contract in this construct is an interest only, non-amortizing and non-reporting contract. The third party payment processor ensures that the installment contract interest payments are processed monthly directly from the intermediary to the Seller and from the Seller to the Lender. The Seller authorizes and instructs the Payment Processor to accept interest payments from the Intermediary and to send interest payments to the Lender, and the Intermediary/Dealer provides the Payment Processor authorization to withdraw payments. All interest payments are, therefore, timely made, for all parties to the transaction, and the Payment Processor provides an annual statement of interest income and interest expenses.

Secondly, each contract has a provision explaining that there are “no adverse effects” to or for the buyer. The final purchase of the physical asset is not affected in any way by the transactions between the Intermediary, the Seller, and the Lender. There are no additional mark-ups to the sales price, and all terms from the Buyer’s standpoint remain as agreed. In fact, the Seller actually delivers title to the asset directly to the Buyer.

Thirdly, the installment contract remains unsecured for the entire thirty (30) year period of the loan. The loan to the Seller is from a private lender (not a bank), and is not secured by the asset sold or the sale proceeds. The Lender agrees by contract to (a) not to report the loan to third parties (collection agencies, etc.); and (b) not to pursue default against the Seller in the event of third party default. The terms of the loan arrangement provide that the only recourse the Lender has is exclusively against the Intermediary in the event of default.

Lastly, the loan itself is a fixed rate, interest only, for the entire term of the loan. Payment of the Principal to the Lender upon at the close of the thirty (30) year term of the loan. Loan proceeds are immediately available to the Seller for re-investment, and no seasoning for the re-investment is required.

Example Scenarios

Summary Example 1

A home is being sold for a total purchase price of $2,700,000. Mr. & Mrs. Seller desire the home to enter into an installment sale transaction.  The current debt associated to the asset is estimated at $0.00.  For calculation purposes the assumed percent of tax is estimated at 30%.  (When able to do so, the clients CPA or accountant is to provide a fixed dollar amount or percentage.)  The price basis will be considered to be $500,000 since a standard deduction clause should be applicable. Based upon the estimate rate, the following estimated financial summary has been outlined:

Summary Example 2

A company owned by multiple partners is being sold for a total purchase price of $32,000,000.  Mr. Seller owns 25% of the asset being sold and desires to enter into an installment sale transaction.  The current debt associated to the asset is estimated at $3,500,000.  For calculation purposes the assumed percent of tax is estimated at 34%.  (When able, please have the clients CPA or Accountant provide a fixed dollar amount or percentage).  Based upon the estimated rate, the following estimated financial summary has been outlined:

Based upon historical averages, it is estimated that by setting aside 20% of the “to-be-paid capital gain tax balance” in an interest bearing product obtaining equal to or greater than 6.5% interest or 5% net of tax, the balance will accrue over a period of 30 years to reach an amount greater than or equal to the tax amount due. A permanent life insurance product with a death benefit equal to the tax liability is, therefore, often recommended because the death benefit can fund the tax liability in the event the Seller dies before the tax comes due in year 30, or the cash value in the insurance policy can be used to pay the tax liability in the event the Seller is still alive at the time the tax comes due.

In this example, the set aside is estimated to be $484,500. This is only a hypothetical estimate which should be detailed and confirmed with the client’s financial advisor.  (Note: If an adviser is needed to model and structure this type of investment, you may contact the writer for a referral). With the set aside amount factored in, the net loan proceeds to the borrower is estimated to be $6,074,250.

It should be noted that the amount set aside, as outlined above, will remain an asset of the borrower, although it is ear-marked for a singular purpose. It must also be noted that the lender is not interested in providing a consumer loan; it provides business loans which is why the lender requires confirmation that the funds will be re-invested.  Having an entity (corporation, LLC, or other) in place would provide the borrower many options to reinvest the loan proceeds.

Concluding Thoughts

The system is NOT driven by Tax Deferral. It is a method for supplying less risky Financing Opportunities. It is, in essence, a Lending/Capitalization Strategy. In 2014 the system was utilized in a Federal Bankruptcy Case. Moreover, Third-party Legal Opinions have been provided for in the past pursuant to how each case applied the strategy.

In case you’re wondering, there is abundant education and support for the Parties involved in the Transaction, and there is ample access to experienced and reputable capital asset dealers (or lenders). Legal assistance for structuring and review of the transaction components is also available, and a referral network of Tax Attorneys for Opinion Letters is provided for each client.

As a parting thought, what the installment sale contract, as configured in this strategy, allows the Seller to do is to sell his asset today and then re-invest the sales proceeds on his/her own timeline! If the asset sold is real estate, this means that the Seller does not have to utilize a 1031 Exchange to re-invest in real estate, but instead may re-invest in real estate to the extent the Seller desires when the Seller Desires!

Unfortunately, this “conventional wisdom” has its perils – especially for highly compensated individuals. For the highly compensated, retirement plans are a potential tax – trap. There are three reasons for this: (1) they will likely pay income taxes at the same or a higher rate at the time they actually access their retirement plan; (2) they may not need any of the retirement funds during retirement, and (3) perhaps most damaging, any funds left in these plans at death will be cannibalized by taxes. Put simply, retirement plans are “traps” whereby the IRS and state tax authorities recapture huge sums of money at tax rates of 50% to 70% depending on whether your state imposes its own estate and income tax.

You May Pay Tax at the Same or Higher Tax Rates

A common misconception among working people today is that when they retire, they will be in a lower tax bracket. Given the amount of invested assets, inside and outside of retirement plans, as well as the continued long-term growth of the securities markets, many Americans will enjoy retirement incomes that put them in the same tax bracket they are in now.

As an example, Elisa, a highly successful 50 year-old businesswoman has $1.5 million in her profit-sharing plan. By the time she is in her late sixties and begins her retirement, the plan funds, at a conservative rate of return, will likely grow to $5 million. If Yolanda withdraws only the interest from the plan from that point onward, apart from any principal or other sources of income, Elisa and her spouse will be taxed on this withdrawal at the highest federal and state income tax rates for the rest of their lives.

What this means is that for highly compensated individuals, the real value of the tax deductions and deferrals afforded retirement plans is not as great as “conventional wisdom” would have one believe. Clients like Elisa have no tax arbitrage available to them. Rather, they simply get the deduction at one tax rate and then pay the tax on withdrawals at the same rate. In fact, retirement plans may actually cause “reverse arbitrage” whereby the plan distributions will be taxed at maximum ordinary federal income tax rates of 39.6% while gains outside the plan will be subject to the lower capital gains tax rates of 15-20%. Hence, there are situations where the retirement plan becomes a veritable “fool’s game” for the taxpayer.

You May Not Need Your Retirement Funds in Retirement

Because the amounts contributed to retirement plans are relatively small for highly paid individuals, most will accumulate significant non-plan assets over their careers. If plan contributions are capped at $55,000 or less in most cases, what happens to the rest of your after-tax earnings? Over the span of your working life, one will likely invest a substantial portion of this capital in equities, rental property, or other income producing investments. The cumulative income from these non-retirement plan investments can generate significant retirement income – so much so that your retirement plan assets are hardly necessary. Although this is an enviable problem, it is nevertheless a problem that must be addressed.

Pavithra, an attorney, has been in practice now for thirty years and she has contributed $20,000 per year for the past for each of the last 25 years; meanwhile, she and her husband have also amassed $1 million in other investment accounts. By the time Pavithra retires at age 65, she’ll have enough in her brokerage accounts for a very comfortable retirement.

As can be seen in Table 1, below, Pavithra – who earned about $275,000 per year for the thirty years she practiced – did not even maximize her pension contributions over that time (more was allowed in each year she contributed). Instead, she chose to control some of her investments herself (about $20,000 per year) in a separate investment account. By the time she retires at age 65. Pavithra will clearly have enough to fund her retirement (she and her husband need about $10,000 per month after tax to live) just from her non-pension plan investments.

To be extremely conservative, let’s advise Pavithra and her husband to keep another $1.4 million of the retirement plan funds secured for emergencies. That still leaves $3 million of the pension at age 65 – which will continue to grow. Pavithra and her husband believe that this $3 million, plus most of its growth, will benefit their children and grandchildren – as they have designated in their will and living trust. As you will see below, they are really benefiting the IRS and state tax agencies because 50% or more of the funds will end up being lost to taxes if they don’t modify their planning.

Remaining Funds Will Be Decimated By Taxes

The question becomes thus: What happens to the assets left in the retirement plan if it is not used by the taxpayer and spouse in their lifetimes? Would it surprise you to know that the vast majority of these funds will likely end up with the state and federal tax agencies? Did it occur to you that after you’d paid taxes for a lifetime of work your “tax qualified” plan would be taxed at rates between 50% and 65%? Upon learning this, most clients are shocked and appalled and want to learn something about it. Before learning what you can do about it, let us take a look at how these taxes are levied. The first thing that must be learned is what the term “IRD” means.

The Basics of IRD

IRD means “income in respect of a decedent” (a deceased person). This is income that would have been taxable to the decedent had the decedent lived long enough to receive it. Whoever receives these items of IRD (e.g., an heir) must report them as gross income and pay any resulting income taxes for the year in which the taxable items are received – typically the year of death.

The IRD is an income tax that is assessed in addition to any federal estate (death) taxes and state inheritance taxes that are due. Because federal and state income taxes (including those characterized as IRD) can reach up to 50% or more in some states, and estate taxes are assessed between 37% and 40% (40% will be assumed here), one can see how quickly the combined rate escalates. Although the rules provide for a partial income tax credit for estate taxes paid, the total tax on assets can be over 60% in some cases.

What types of assets qualify for the dreaded IRD treatment? Income earned by the decedent but not yet paid, such as bonuses or commissions, qualifies as IRD. Once these assets are paid to the estate, they’ll be hit with income taxes and estate taxes under the IRD rules. What is the most likely and significant asset exposed to IRD? Retirement plans, such as pensions, 401(k)’s, and IRA’s (to the extent contributions were originally tax deductible).

How IRD Eats Up a Retirement Plan – An Illustration

To illustrate, suppose Yasmeen, a single physician, whose other assets easily exceed the current estate tax exemption. Her IRA is fully taxable as it was funded entirely with tax- deductible contributions. (The same illustration could be made for a married couple but the estate tax may be deferred until the second spouse dies if he/she were the retirement plan’s beneficiary due to the unlimited marital deduction).

Yasmeen’s fully taxable retirement plan of $1,000,000 is held in her IRA, Yasmeen’s estate or heirs would first pay $400,000 in estate taxes ($1,000,000 x 40%), and then pay another $270,000 in income taxes (i.e., 45% of the remaining amount after allowing a deduction for federal estate taxes paid). Thus, only $330,000 is left from the IRA for Yasmeen’s beneficiaries – less than 40%! Approximately 67% of the funds – built over a lifetime of working and paying income taxes – were taken by the IRD tax system. Table 2, below, shows us how that happened:

How to Avoid the Tax Trap

In many cases, it may make sense not to use qualified plans in the first place – especially if you can accurately forecast not needing those funds in retirement. If, after a financial analysis, it looks as though the retirement plan proceeds will end up as part of an estate plan, one should consider ending the participation as soon as possible – as long as asset protection issues are analyzed as part of a comprehensive plan.

What if you have already built up a large plan balance and now realize that you don’t need most or all of the funds in retirement – like Pavithra in the earlier example? Unless you want 60% or more of these funds to go to state and federal taxes, you must do something and the earlier, the better. This may involve the use of advanced estate planning techniques, often requiring a rollover of the retirement plan, the creation of a special purpose qualified plan, and a combination of legal and financial disciplines. While the details of such techniques are beyond the scope of this article, suffice it to say that with advanced planning, the threat of significant IRD can be eliminated from your estate plan. In Pavithra’s case, for example, we might be able to save her $4,400,000 pension from over $2.7 million in IRD and estate taxes. In fact, we might able to leave in excess $10 million to Pavithra’s children and grandchildren tax-free by utilizing her retirement plan funds in a more tax-efficient manner.

Conclusion: Talk to an Expert

Navigating your way through retirement plan dilemmas requires expertise in financial planning and forecasting, tax law, and estate planning. It is crucial that you consult a professional with experience in dealing with retirement plans and, if relevant, techniques for preserving plan assets from the ravages of income and estate taxes.

As an asset protection attorney whose focus is on high net worth clients, it is our job to create structures which protect our clients’ wealth against risks that range from business lawsuits to personal creditor claims. In creating such “asset protection plans,” we often utilize offshore structures – especially for clients with significant liquid assets. Here, we will briefly describe one offshore structure we use quite often, the Nevis Limited Liability Company (“LLC”).

Traditional LLC Protection

Many smart investors place their rental property, valuable business equipment and real estate, and brokerage accounts into separate limited liability companies (LLCs) to protect that wealth from lawsuits. How do LLCs (domestic or offshore) protect wealth?  If you lose a case and the creditor has secured a judgment against you, the creditor cannot seize the assets of your LLC. That creditor can only obtain a “charging order” against your LLC interest.  This “charging order” limits the creditor to recovery of your share of any distributions actually made from the LLC.  If you, or you and your spouse, are managing members, would you ever vote to pay distributions if you knew a creditor would be able to intercept the distributions?  The answer is, obviously, no.  The “charging order” does not allow the creditor to partition your interest in the LLC or vote your interest. In this way, the assets within the LLC are shielded. Only when you have decided to make distributions does the creditor get anything of value.  In practicality, the plaintiff’s attorney usually recommends a “pennies on the dollar” settlement rather than asking his client to wait 25 years or more for any recovery.  Some attorneys won’t even waste their time attacking LLCs.  The IRS, in fact, is loath to pursue charging orders against individuals who owe them money.

Which States Have Superior LLC Laws

Many attorneys will simply establish an LLC for a client in the state in where they operate. For asset protection purposes, this can be a critical mistake.  Most states do not make the charging order the exclusive remedy of LLC creditors in their state statute.  Thus, a judge could grant a creditor a different remedy if he/she so chose, including dissolution – which would result in the client losing their proportionate share of the underlying asset.

While these circumstances may be rare, the above scenario is possible in some states.  Superior planning dictates the use of LLCs created in states where – by statute – the charging order is made the exclusive remedy available to creditors.  These are the most powerful and flexible asset protection tools in the states and ideal for owning wealth where offshore planning cannot be utilized (particularly with real estate).

Why Go Offshore

From the standpoint of litigation deterrence and protection, the benefits of offshore planning are significant. These factors are the driving force of offshore planning in the U.S.  However, there are other reasons to consider international planning.  These are:

1. Asset Protection: Many Americans put their money offshore to protect it from present and future creditors.  As we have discussed in other articles, this is a legally permissible goal, as long as the structures and transfers comply with various S. laws.  Offshore planning can provide a powerful level of asset protection which domestic planning simply cannot achieve.
2. Tax Planning: A common – and extremely dangerous – misconception about offshore planning is that simply by going offshore, one can avoid S. taxation. Simply put, this is dead wrong. Americans are liable for taxes on income, wherever earned.  The vast majority of solid offshore asset protection plans are tax neutral – although there may be significant tax advantages gained from a number of offshore insurance structures.  However, the LLC can be the underlying ownership entity of structures that do have legitimate tax benefits – such as captive insurance companies and tax-deferred annuities.
3. Privacy: While proper offshore planning always includes full disclosure to the relevant S. governmental agencies, clients can gain a tremendous amount of financial privacy in offshore jurisdictions.  For many individuals and families, this is a significant benefit in today’s world, where personal financial information is easily accessed through public records and through the internet.
4. Investing: Today, our world is a global village. No longer are American stocks, bonds, and mutual funds the only safe, lucrative investments. In fact, the opposite may be true.  Economists and financial analysts agree that most of the economic growth in the next 50 years will occur in Asia, Eastern Europe and other developing nations, like Brazil and Vietnam. Many clients use offshore vehicles to diversify their risk and enjoy better returns by investing in foreign markets and taking advantage of trends in currency exchange rates relative to the American dollar. Moreover, there are a number of provocative, perhaps superior, investment “products” available offshore that one cannot simply find domestically.

Nevis LLCs: Background

Like an LLC in any state, the Nevis LLC is a “hybrid” entity, partly like a corporation and partly like a partnership. However, more so than other American entities, the Nevis LLC has been designed to be an ideal asset protection entity.

When Nevis – a small Caribbean nation that is part of a Federation with St. Kitts – began to compete for the multi-billion (US$) asset protection business earlier in the 1990’s, it revised its trust and business entity laws. As part of this process, the lawmakers studied American LLC statutes and improved on them, in terms of providing asset protection for American citizens. The result is a superior asset protection tool used by many attorneys specializing in the field.

Why the Nevis LLC Is Better Than Its Domestic Counterpart

Like all offshore tools, the Nevis LLC acts as a powerful litigation deterrent – as most plaintiffs and their lawyers do not know how to approach getting to assets owned by foreign structures.  Thus, in most cases, just by disclosing how the Nevis LLC protects a client’s assets, we can deter a possible lawsuit or settle an outstanding claim.  This works in the vast majority of cases – making the Nevis LLC more attractive than its U.S. counterparts.

Nonetheless, if a persistent creditor wants to attack the Nevis LLC, he might ask as U.S. court to dissolve the structure or order assets back.  However, because this entity is an LLC, with “charging order” protections like those in the United States, the courts do not have the same difficulties in evaluating foreign LLCs as they have with offshore trusts.  Whereas offshore trusts take advantage of another country’s laws which differ from those of the U.S., the Nevis LLC laws were drafted to replicate U.S. laws.  Clients with foreign LLCs are taking advantage of the same statutes as those in the states – an important factor in having U.S. courts respect this particular form of entity.

If a creditor cannot attack the Nevis LLC in the U.S., he could attempt to do so in Nevis.  To do this, Nevis procedural laws require that he must begin a new lawsuit on the underlying claim (i.e., malpractice), post a bond of at least $25,000, and be forced to hire a Nevis lawyer on an hourly basis because Nevis does not permit American lawyers to practice in their jurisdiction and does not permit attorney fees on a contingency basis. Hence, we have yet another reason why Nevis LLCs deter lawsuits. How would a U.S. attorney feel about the prospect of losing fees from the case to a foreign lawyer?  They would rather settle the case or drop it entirely.

Suing in Nevis is a time-consuming, expensive and unfamiliar process.  It is not surprising, therefore, that we have yet to see a creditor make such a successful attack.

• Tax Benefits

The Nevis LLC is tax neutral, like a domestic LLC. In terms of estate planning, the LLC can be used a part of a gifting program to move value out of a couple’s estate by moving ownership units to children.  This can be accomplished while the clients (parents) maintain 100% control of the LLC.

• Funds Offshore Are Secure & Invested Wisely

Funds held by Nevis LLCs can be housed in some of the world’s largest banks (i.e. Barclay’s) and invested in grade AAA investments (i.e., Swiss Annuities). Thus, clients can sleep well, knowing their savings are safe and growing.

Case Study: “Protected Howard” Settles Claims for Pennies

Howard, a general client, is well-respected in his community.  While he had been sued before (he never lost), Howard recently heard of a claim $1 million over coverage limits being made successfully against a colleague. He decided to engage an asset planning strategy.

Howard set up a wealth preservation plan, part of which involved transferring his non-pension liquid assets to a Nevis LLC.  The LLC then established a bank account, through which he then purchased a high-grade tax-deferred variable annuity from a multi-billion dollar Swiss insurance company.

When Howard was later threatened with lawsuits, he no longer worried about losing what he’d already earned. Instead, Howard now feels secure, knowing that his most important assets are safe from all creditors, and that he is no longer at the mercy of the lawsuit and the legal system.

Challenges

As with any offshore tool, the challenge in implementing strategies for your clients is to have the process go smoothly and for the funds invested through the structure to be secure.  We have the contacts at offshore fiduciary firms, banks, insurance companies, and investment houses to assist you in this process.  This will make all the difference in moving into the cutting-edge and niche of offshore planning.

While many U.S. asset protection experts are using Nevis LLCs in place of offshore trusts, there are still instances where the trust may be preferable, particularly when estate planning is a priority.  Nonetheless, for achieving a wide variety of financial or legal objectives, the Nevis LLC is an alternative structure for offshore financial planning that should always be considered.

It must also be noted that operating an offshore entity also means that American residents and citizens must report all income from the operation of this entity. American tax law requires that Form 8938 and a Foreign Bank Account Report (“FBAR) be filed annually with few exceptions. Hence, placing assets offshore does not mean that one can hide offshore income from American tax authorities.

Before you set sail or take the yacht for a nice Caribbean cruise or dive adventure, consider setting up your asset protection plan first and, maybe, that trip will be a business trip for your annual meeting for your LLC as well.

If You Do Nothing, the IRS May Get Almost Half of Your Policy

The greatest misconception most clients have when it comes to life insurance is that the proceeds are estate tax free. This is absolutely wrong! The proceeds are income tax free … but estate taxes are worse than income taxes. After the exemption amount, estate taxes quickly rise up to 40%!! Thus, if you and your spouse have an estate over the exemption amount when you die, you could lose 40% of the proceeds to Uncle Sam. Why lose potentially hundreds of thousands of dollars after you paid those premiums so diligently when a simple trust can take the IRS out of the picture and provide better protection for your beneficiaries?

What the Irrevocable Life Insurance Trust Is

An irrevocable life insurance trust (ILIT) is simply an irrevocable trust which has a life insurance policy as an asset. Like all other irrevocable trusts, the ILIT requires a written document, a trustee, a beneficiary, and the terms of the trust distribution. A properly drafted ILIT should also have in its preamble that the purpose of the trust is tax savings by utilizing a particular life insurance policy.

In essence, the ILIT owns a policy which insures your life. The policy itself will name the trust as beneficiary so when you die, the insurance company pays the proceeds to the ILIT trustee. Then the ILIT trustee will follow your trust instructions on what to do with the proceeds, including paying the ILIT beneficiaries you named in the trust document. The trust must make all payments of premiums. You can gift funds into the trust each year to pay for the premiums.

An ILIT Can Save You Big $$ In Estate Taxes

In short: simply by setting up an ILIT, you can save hundreds of thousands if not millions of dollars in estate taxes! An ILIT saves you estate taxes because the ILIT, rather than you personally, owns the life insurance policy. Because the policy is not owned in your name, the policy proceeds will not be part of your net estate when you die. Thus, they will not be subject to the estate tax. This can save your family a lot of money. Consider this example:

Let us assume that you are single when you die and that your estate will be worth $20 million at the time of your death, $2,000,000 of which is life insurance. Let us also assume that you have the full amount of your $5,450,000 estate tax exemption when you die. Because the first $5,450,000 of your estate is exempt from tax, your estate will have to pay taxes on the remaining $14,550,000 — an estate tax bill of over $_________________________ (14,550,000 x 40%) under current tax rates! By using an ILIT, you can get that $2,000,000 of life insurance value out of your estate, thereby saving your family almost $800,000 in estate taxes!

In this way, if you would ordinarily be in a 40% estate tax bracket, you can effectively more than double the amount of proceeds your beneficiaries get from the policy by using an ILIT. You are simply taking the IRS out of the equation … legally.

An ILIT Also Gives You Control

The ILIT gives you much more control over what happens to the policy proceeds than you would get from a bare insurance policy. With an insurance policy alone, your only decision is who to name as beneficiaries, and the insurance company will simply pay these people when you die. Life Insurance carriers typically offer only a few settlement options. With an ILIT, on the other hand, you can control not only who gets the proceeds, but even more importantly, you can customize exactly happens to the funds when you die.

An ILIT can provide that the trustee will pay costs, such as probate costs, legal fees, other debts, etc., before paying any trust beneficiaries. You can have the trustee pay the beneficiaries directly or pay them over a period of months or years. You can incorporate spendthrift provisions and anti-alienation provisions to protect against your beneficiary’s (children) financial problems, creditors, or their spouse in the event of divorce. In fact, an ILIT gives you all of the benefits of a trust arrangement while allowing you to provide for your family just as you would with a bare insurance policy.

For these reasons, an ILIT should be used to own almost every life insurance policy and one can readily see why they are a vital part of a client’s estate plan.

1.0 Entity Status. Limited Liability Companies are legal entities. An entity is established so that the entity has a legal existence separate from its ownership (“members”). If a Limited Liability Company is an entity that has a legal existence separate from its ownership, personal assets are not subject to the Limited Liability Company’s creditors, including judgment creditors, except to the extent that the members have agreed to be personally liable, such as by signing a personal guarantee, by signing an agreement or note as a co-obligor, or by providing personally owned assets as security. Here are some key definitions:

1.1 Members. The owners of a Limited Liability Company are called “members” and their interests are usually represented by share certificates representing a number of shares in the Limited Liability Company. Different types of shares can be issued with different rights relative to managerial rights, participation in income distributions, and participation in the company’s asset upon liquidation.

a) Managers and Officers The members may elect one or more managers who direct the affairs of the Limited Liability Company. The managers and/or members may elect the Limited Liability Company’s officers, such as President, Vice-President, and Secretary-Treasurer, although officers are not required. The managers are the day to day decision makers of the Company, and the members typically have voting power over major policy decisions of the Company, although the issues over which the members have the right to vote may vary from LLC to LLC depending on Operating Agreement the members put into force.

1.2 Multiple Roles. Under California law, a Limited Liability Company only needs one member, one manager, and one person acting in the role of several officers. However, where there is only one member, the entity is disregarded for income tax purposes and, under California law, a single member LLC is not afforded the same creditor protection rights as an LLC that is a bona fide partnership. Consult with my office if you are concerned or are interested in learning more about the difference between the single member LLC or what constitutes a bona fide partnership.

2. ORGANIZATION

2.0 Formation: A Limited Liability Company’sformation is governed by state law. If a Limited Liability Company formed in one state wishes to do business in another, it must qualify to do business in that other state according to the laws of that state.

2.1 Articles of Organization. A Limited Liability Company is formed by filing “Articles of Organization” with the Secretary of State. The Articles are usually brief, containing only the most basic information about the Limited Liability Company that is being formed. The Articles set forth the name of the Limited Liability Company, location of the principal office, the name of the agent for service process, the names of the initial members and managers, etc. The Articles of Organization are simple, but they are only a part of the formalities that must be followed in order to be entitled to the benefits of LLC status.

· Resident Agent. The Limited Liability Company must appoint a party to serve to serve as the “resident agent” or “agent for service of process”. This is a person or business in California that agrees to be served with papers in the event of lawsuit. This agent must accept that position in writing, and that written acceptance must be filed with the Articles of Organization.

· 60-Day List. Within sixty days of the filling of the Articles of Organization, an officer of the Limited Liability Company must sign a Statement of Information containing the names and mailing addresses for all managers of the Limited Liability Company.

2.2 Operating Agreement. The Operating Agreement outlines the government of the Limited Liability Company. The Operating Agreement specifies the duties and responsibilities of the Limited Liability Company’s members, managers, and officers (if any). While the Articles of Organization are usually very brief, the Operating Agreement is usually much more detailed, including information regarding meetings and the Limited Liability Company’s technical operations. Sometimes the Articles will contain provisions that may be modified by the law, but the general rule is that a provision in the Articles of Organization will take precedence over a contrary provision in the Operating Agreement.

2.3 Organizational Meetings Once the Limited Liability Company has been legally formed by filing the Articles of Organization, the Limited Liability Company must be organized. The managers named in the Articles must authorize the issuance of shares, elect officers (if any), and adopt the Operating Agreement. The managers may also want to approve a corporate seal, authorize the opening of one or more banks accounts, and make other decisions relating to the start up of the business or transition into the LLC form.

2.4 Share Issuance. Shares certificates should be issued to each member. Each person receiving shares must pay for the shares, but the payment can be in almost any form, including promissory notes and services.

3. ADMINISTRATION

3.1 Maintenance: A Limited Liability Company requires maintenance. If it is not properly maintained, it may be ignored. If you need assistance with any of this, please contact us or another qualified professional.

3.2 Financial Records. A business’s most important records are its financial records. Corporate accounting records should be kept current, and all tax returns should be filed. The Limited Liability Company’s financial records must be maintained separate from those of any manager, officer, or member. The Limited Liability Company must have a separate tax identification number, which should be used for all corporate transaction and tax returns, Corporate assets, including bank accounts, investments, real property, and vehicles should be titled in the name of the Limited Liability Company if the Limited Liability Company is the intended owner. If a member or employee of the company uses corporate assets for personal use, he or she must either pay rent or recognize taxable income (in accordance with acceptable business accounting practices and in accordance with applicable tax laws). Once the Limited Liability Company is formed and officially recognized, one should never pay an LLC obligation with a personal check, and one should never pay a personal obligation with an LLC check.

3.3 Meetings. The members and managers should meet as often as necessary to hold elections and make decisions, and probably not less than once a year. It is common to have the members’ and managers’ meetings together or on the same day.

a) Minutes of the meetings are kept to record the decisions that are made, usually documented in the form of “resolutions” that are adopted pursuant to parliamentary procedure.

b) California law permits resolutions to be adopted in the absence of a formal meeting, if a “consent resolution” is utilized.

· As to decisions made by the managers, the consent resolution must be signed by all managers. This is sometimes referred to as a “unanimous consent resolution;”

· As to decisions made by the members, the consent resolution must be signed by the number of members that would have been required if a meeting had been held, and all eligible to vote had attended.

c) We recommend that at least once a year the members elect the managers and officers, if any, of the Company. Of course, the officers and managers can be elected for more than a one-year term, and the election of various managers and officers can be staggered so that all are not elected during any one election. These elections may be done at a meeting or by consent resolution (as discussed in paragraph 3.2 (b), above).

3.4 Business License. You must comply with all applicable local ordinances in the operation of the Limited Liability Company’s business. Obtain and maintain all required business licenses. Contact city, country, and/or state agencies to make sure that you have been licensed by all appropriate authorities

3.5 Trade Names, Trade Marks, Copyrights, and Patents. You cannot operate a Business using the name of a company or product that is the same or “deceptively similar” to the name already in use by another individual business. Similarly, you cannot conduct business in violation of applicable copyright and patent law. You are responsible to make sure you are not infringing on the rights of others, and you may need to take steps to discourage others from violating your rights, and to do this, it may be advisable to engage a patent and trademark attorney.

3.6 Employees. You must follow federal, state, and local laws relating to employment, payroll taxes, worker’s compensation insurance, occupational safety, and all other laws and regulations relating to employees.

4. PROTECTING AGAINST LIABILITY

4.1 The “Alter Ego” Rule. A Limited Liability Company will be ignoredby the courts if it is deemed to be nothing more than the “alter ego” of its members.

a) The “alter ego” argument is used by company creditors where the Limited Liability Company has debt that the Limited Liability Company itself is unable to pay. Such creditors want the Limited Liability Company to be ignored so that they can seek payment from the Limited Liability Company’s owners, and they can be successful in having the Limited Liability Company disregarded as a legal entity if the corporate formalities are not observed,if personal and corporate assets are commingled, if personal obligation are paid for out of the company funds, if company assets are used for personal use without payment or without being treated as part of an employee’s compensation, and/or if corporate financial records are not properly kept;

b) The “alter ego” will not be applied to a Limited Liability Company that keeps accurate records of its meetings of managers and members, that keeps its financial affair completely separate from those of its members, that has its financial records maintained or at least reviewed by a certified public accountant, and that makes sure that all business is conducted in the LLC’s name.

4.2 Co-Obligor vs. Guarantor. For new Limited Liability Companies without a solid net worth and an established business track record, it is common for a company creditor (referring to anyone who extends credit to the Limited Liability Company) to require a member whose financial resources are substantial to either be a guarantor or co-obligor with the Limited Liability Company.

a) A “guarantor” is one who has agreed to meet the Limited Liability Company’s obligations if the Limited Liability Company is unable to do so. Traditionally, a guarantor could not be held responsible for a guaranteed obligation unless and until the creditor had exhausted its remedies against the primary obligor, the Limited Liability Company;

b) A Limited Liability Company’s creditor may consider the enforcement of a guarantee unnecessarily burdensome, and so it is common for the creditor to insist that the member be a “co-obligator” with the Limited Liability Company. It is not common to see the world “co-obligor” in a written agreement, but it is common to see a provision that makes the Limited Liability Company and the member “jointly and severally liable”. Such a provision allows the creditor to sue either the Limited Liability Company or the members or both, and the member could be required to pay the entire obligation if the Limited Liability Company to do so.

Of course, there are arrangements that amount to a cross between a guarantee and a joint obligation, requiring the creditor to make some attempt to collect the obligation from the Limited Liability Company first, but not requiring the creditor to exhaust all remedies before turning to the members. So, while a Limited Liability Company exists to eliminate a member’s personal liability for LLC obligations, a member can negate the protection by signing an agreement that makes the member a guarantor or co-obligator.

5. CONCLUSION

If you are going to establish a Limited Liability Company, do it right. This will involve the observance of proper legal formalities, and it requires the advice of qualified financial advisors.

5.1 Business Formalities. A Limited Liability Company should not conduct business as a Limited Liability Company until it has been properly formed under state law. This means, at a minimum, that the Articles of Organization must be accepted by the Secretary of State, and that the members have met to elect managers and adopt an Operating Agreement, and the members have met to adopt resolutions regarding the operation of the company’s business

5.2 Financial Affairs. The most important advisor for a Limited Liability Company is its accountant. Making sure that financial records are properly kept and tax returns are timely filed will go long way to preserve the Limited Liability Company’s good standing and continued legal existence. Of course, if investments are to be maintained, an investment advisor should also be consulted.

5.3 Legal Matters. Business operations rely on compliance with the law, and the company’s attorney can assist in discovering what laws apply and how to comply with those laws. In addition, it is a rare business that will not be involved in negotiating, signing, and complying with legally binding contracts. Sometimes it can be penny wise and pound foolish for company managers who are not attorneys to act without advice of legal counsel. Similarly, a member or manager who is asked to sign an agreement as a guarantor or co-obligor should not do so without the advice of independent legal counsel.

1. ENTITY BASICS: A Corporation is a legal entity that that is established to do business. A corporation is established so that the corporation is an entity that has a legal existence separate from its owners (the “shareholders”). If a Corporation is properly formed, the shareholder’s separate personal assets are not subject to the corporation’s creditors, including judgment creditors, except to the extent that the shareholders have agreed to be personally liable, such as by signing a personal guarantee, by signing an agreement or note as a co-obligor, or by providing personally owned assets as security. Here are some key definitions:

1.1 Shareholders. The owners of a corporation are called “shareholders or “stockholders” because their interests are usually represented by stock certificates representing a number of shares in the corporation. Different types of stock can be issued with different rights relative to voting rights, participation in dividends, and participation in the proceeds of any sale of the company’s assets upon liquidation.

1.2 Directors and Officers The shareholders elect one or more directors who direct the affairs of the corporation. The directors elect the corporation’s officers, such as President, Vice-President, Secretary and Treasurer. The directors are the policy makers, and the officers are employed by the corporation to put the directors’ policies into effect.

(a) In large corporations, the board of directors may select a “Chairman of the Board,” and the board may be subdivided into committees with specific authority. It is also common to have “executive committee” that has authority to make certain decisions without approval by the full board of directors.

(b) In addition to the traditional corporate officers, there can be other officers,

including chief executive officer (CEO), chief operating officer(COO), and

1.3 Multiple Roles. In most states, a corporation only needs one shareholder,

one director, and one person acting in the roles of several officers. In a large corporation, the chairman of the board may be the CEO, or the chairman of the

executive committee may be the CFO.

2. Formation: A corporation’s formation is governed by state law. If a corporation

formed in one state wishes to do business in another, it must qualify to do business

in that other state according to the laws of that state.

2.1 Articles of Incorporation. A corporation is formed by filing “Articles of Incorporation” with the Secretary of State. The Articles are usually brief, containing only the most basic information about the corporation that is being formed. The Articles set forth the name of the corporation, location of the principal office, the name of the agent for service process, the number of shares of stock, and the names of the initial officers and directors, etc. The Articles of Incorporation are simple, but they are only a part of the corporate formalities that must be followed in order to be entitled to the benefits of corporate status.

(a) Resident Agent. The corporation must appoint to serve as the “resident

agent” or “agent for service of process.” This is a person or business in the state of corporation that agrees to be served with papers in the event of a lawsuit. This agent must accept that position in writing, and that written acceptance must be filed with that Articles of Incorporation.

(b) “60-Day List. Within sixty days of the filing of the Articles of Incorporation, an officer of the corporation must sign a list containing the names and mailing addresses for all officers and directors of the corporation.

2.2 Bylaws. The bylaws outline the government of the corporation. The bylaws

specify the duties and responsibilities of the corporations shareholders, directors

and officers. While the Articles of Incorporation are usually very brief, the

bylaws are usually much more detailed, including information regarding

meetings and the corporation’s technical operations. Sometimes the Articles

will contain provisions that may be modified by the bylaws, but the general rule

is that a provision in the Articles of Incorporation will take precedence over a

contrary provision in the bylaws.

2.3 Organizational Meetings Once the corporation has been legally formed by

filing the Articles of Incorporation, the corporation must be sign organized. The

directors named in the Articles must meet to authorize the issuance of stock,

elect officers, and adopt the bylaws. The directors may also want to approve a

corporate seal, authorize the opening of one or more banks accounts, and make

other decision relating to the start up of the business or its transition into

corporate form.

2.4 Stock Issuance. Stock certificates should be issued to each stockholder. Each

person receiving stock must pay for the stock, but the payment can be in almost

any form, including promissory notice and services. Anyone receiving stock for

services must report the value of the stock as taxable compensation on his or her

income tax return.

3. Maintenance: A corporation requires maintenance. If it is not properly maintained, it may be ignored. If you need assistance with any of this, please contact us or another qualified professional.

3.1 Financial Records. A business’ most important records are its financial

records. Corporate accounting records should be kept current, and all

tax returns should be filed. The corporation’s financial records must be

maintained separate from those of any director, officer, or shareholder.

The corporation must have a separate tax identification number, which should be used for all corporate transactions and tax returns. Corporate assets, including bank accounts, investments, real property, and vehicles should be titled in the name of the corporation where appropriate.[1] If a shareholder or employee of the company uses corporate assets for personal use, he or she must either pay rent or recognize taxable income (in accordance with acceptable business accounting practices and in accordance with applicable tax laws). Once the corporation is formed and officially recognized, no one should pay ever pay a corporate obligation with a personal check and no one should pay a personal obligation with a corporate check.

3.2 Meetings. The shareholders and directors should meet as often as necessary to

hold elections and make decisions, not less than once a year. It is common to have the shareholders’ and directors’ meetings together or on the same day, and

for closely held businesses where the shareholders and directors are the same people, the meeting of the shareholders and directors can be a joint meeting.

(a) Minutes of the meetings are kept to record the decisions that are made,

usually documented in the form of “resolutions” that are adopted pursuant

to parliamentary procedure.

(b) In the most states, the law permits resolutions to be adopted in the absence of a formal meeting if a “consent resolution” is signed.

(1) As for decisions made by the board of directors, the consent resolution

must be signed by all directors. This is sometimes referred to as a

“unanimous consent resolution.”

(2) As to decisions made by the shareholders, the consent resolution must

be signed by the number of shareholders that would have been required

if a meting had been held and all eligible to vote had attended.

(c) We recommend that at least once a year the shareholders elect the directors

and the directors elect the officers. Of course, the officers and directors can

be elected for more than a one- year term, the election of various directors

and officers can be staggered so that all are not elected during any one election. These elections may be done at a meeting or by consent resolution (as discussed in paragraph 3.2 (b), above).

3.3 Business Licenses. You must comply with all applicable local ordinances in the

operation of the corporation’s business. Obtain and maintain all required business

licenses. Contact city, country, and/or state agencies to make sure that you have

been licensed by all appropriate authorities.

3.4 Trade Names, Trade Marks, Copyrights, and Patents. You cannot operate a

business using a name of a company or product that is the same or “deceptively

similar” to the name already in use by another individual or business. Similarly, you

cannot conduct business in violation of applicable copyright and patent law. You

are responsible to make sure you are not infringing on the rights of others, and you

may need to take steps to discourage others from violating your rights, and to do

this, it may be advisable to engage a patent and trademark attorney.

3.5 Employees. You must follow federal, state, and local laws relating to employment,

payroll taxes, worker’s compensation insurance, occupational safety, and all other

laws and regulations relating to employees.

4. P ROTECTING AGAINST LIABILITY: As stated above, a corporation’s

obligations.

4.1 The “Alter Ego” Rule. A corporation will be ignored by the courts if it is deemed to be nothing than the “alter ego” of its shareholders.

(a) The “alter ego” argument is used by company creditors (whether businesses or individuals) who are owed money by the corporation that the corporation itself is unable to pay. Such creditors want the corporation to be ignored so that they can seek payment from the corporation’s owners, and they can be successful in having the corporation disregarded as a legal entity if the corporate formalities are not observed,if personal and corporate assets are commingled, if personal obligations are paid for out of the company funds, if company assets are used for personal use without payment or without being treated as part of an employee’s compensation, and/or if corporate financial records are not properly kept.

(b) The “alter ego” will not be applied to a corporation that keeps accurate records of its meeting of directors and shareholders, that keeps its financial

affair completely separate from those of its shareholders, that has its financial records maintained or at least reviewed by a certified public accountant, and that makes sure that all business is conducted in the corporate name.

4.2 Co-Obligor vs. Guarantor. For new corporations without a solid net worth and an established business track record, it is common for a company creditor (referring to anyone who extends credit to the corporation) to require a share holder whose financial resources are substantial to either be a guarantor or co-obligor with the corporation.

(a) A “guarantor” is one who has agreed to meet the corporation’s obligations if the corporation is unable to do so. Traditionally, a guarantor could not be

held responsible for a guaranteed obligation unless and until the creditor had exhausted its remedies against the primary obligor, the corporation.

(b) A corporation’s creditor may consider the enforcement of a guarantee unnecessarily burdensome, and so it is common for the creditor to insist that the shareholder be a “co-obligor” with the corporation. It is not common to see the world “co-obligor” in a written agreement, but it is common to see a provision that makes the corporation and the shareholder “jointly and severally liable.” Such a provision allows the creditor to sue either the corporation or the shareholders or both, and the shareholder could be required to pay the entire obligation if the corporation to do so.

(c) Of course, there are arrangements that amount to a cross between a guarantee and a joint obligation, requiring the creditor to make some attempt to collect the obligation from the corporation first, but not requiring the creditor to exhaust all remedies before turning to the shareholders.

(d) So, while a corporation exists to eliminate a shareholder’s personal liability for corporate obligations, a shareholder can negate the protection by signing an agreement that makes the shareholder a guarantor or co-obligor.

5. CONCLUSION: If you are going to establish a corporation, please do it right. This will involve the observance of proper legal formalities, and it requires the advice of

qualified financial advisors.

5.1 Business Formalities. A corporation should not conduct business as a corporation until it has been properly formed under state law. This means, at a minimum, that the Articles of Incorporation must be accepted by the Secretary of State, that the shareholders have met to elect the board of directors and adopt bylaws, and the directors have met to select officers and adopt resolution regarding the operation of the company’s business

5.2 Financial Affairs. The most important advisor for a corporation is its accountant. Making sure that financial records are properly kept and tax returns are timely filed will go long way to preserve the corporation’s good standing and continued legal existence. Of course, if investments are to be maintained, an investment advisor should also be consulted.

5.3 Legal Matters. Business operations rely on compliance with the law, and the firm’s attorney can assist in discovering what laws apply and how to comply with those laws. In addition, it is a rare business that will not be involved in negotiating, signing, and complying with legally binding contracts. Sometimes it can be penny wise and pound-foolish for company officers and directors who are not attorneys to act without advice of legal counsel. Similarly, a shareholder who is asked to sign an agreement as a guarantor or co-obligor should not do so without the advice of independent legal counsel.

[1] If corporate investment assets such as real estate, equipment or investments are considerable, it is recommended that such assets are titled to a separate Limited Liability Company (“LLC”) or Limited Partnership. The LLC or partnership may then lease the assets back to your corporation.

Regardless of your profession, you likely don’t want to pay any more taxes to Uncle Sam than necessary. Also, like most people, you probably want as much of what you earned in your lifetime to go to your spouse or children when you die.  If this describes you, and you are in a marriage where only one spouse is an American citizen, you may be in for a terrible tax surprise when the first spouse dies.  Without the proper planning, the tax costs could be in the hundreds of thousands of dollars if not millions, and the funds remaining may be vulnerable to lawsuits and creditor claims.

This potential financial disaster was created by the IRS in 1989, when it radically altered how non-citizen surviving spouses would be treated for estate tax purposes. For couples where both spouses are U.S. citizens, the “unlimited marital deduction” allows any property left to a surviving spouse to be exempt from estate taxes when the first spouse dies.   In 1989, the IRS took away this deduction for couples where the surviving spouse is not an American citizen.

By eliminating this deduction, the IRS now taxes any property left to the non-U.S. citizen surviving spouse.  After an estate exclusion amount of $60,000 for Non-Resident Aliens and $5.49 million for Citizens and Resident Aliens (‘green card holders”), this estate tax quickly rises to 40%.  For someone leaving a large estate, the taxes can easily reduce a family’s estate in half.  Let’s see how this tax works for the unprepared couple and what type of planning strategy makes sense.

Let us take the example of a businessman here (the occupation of the taxpayer is totally irrelevant). Juan Vargas is an American citizen, while Juan’s wife, Valerie, is a Peruvian citizen and their children are U.S. citizens. Juan and Valerie will have amassed an estate of approximately $10 million, mostly consisting of $4.0 million in real estate $4.0 million in a family business, and almost $2,000,000 in stocks and equities.  The $8 million in property and the family business stock is entirely titled in Juan’s name because he has been the U.S. citizen, and almost all of the $2,000,000 in equities are titled to him as well.  Assume that Juan dies at age 75 and that he leaves all of his nearly $10 million of assets in his Will to Valerie, and that the Unified Tax Credit exempts the first $5,450,000 of Juan’s estate from estate tax.

Because Juan and Valerie are not familiar with the special tax rules for non-U.S. citizens, they wrongly assumed that the marital deduction would cover them, so there would be no tax due on Juan’s death. In reality, Valerie will owe tax on approximately $4,510,000 of Juan’s estate in cash 9 months after Juan dies, or approximately $1.804,000 in estate taxes (40% x $4,550,000).

How will Valerie pay this tax $1.8 million bill? She may have to sell their best piece of real estate at a fire-sale price just to raise the money.  Even worse, she might have to exhaust all of their equities, upon which she may have to sell all of the $2 million worth because those sales may be subject to capital gains taxes as well.

To avoid this “1^st death disaster” tax hit, and to protect their assets from lawsuits as well, Juan and Valerie should establish three trusts: (1) a credit shelter or “Bypass” trust, (2) a Qualified Domestic Trust (QDOT) and (3) an Irrevocable Trust.

The Bypass Trust is a common estate planning trust.  It assures that Juan will be able to pass his lifetime exemption amount — $5,490,000 as of today – estate tax free to Juan’s children. Valerie would also be able to collect income on the $5,490,000 during her life without paying estate taxes (Note: she would still be subject income taxes on this income).

The QDOT is a trust with certain special provisions for non-citizen surviving spouses.  These provisions allow any property left to the trust for the benefit of the non-citizen spouse to qualify for the unlimited marital deduction. However, the QDOT can only pay income to the surviving spouse estate tax-free, distributions of principal will be subject to estate tax.

If Juan and Valerie properly create the Bypass trust for their children, $5,490,000 will go to their children estate tax free.  Moreover, if Juan leaves the rest of his estate to Valerie through the QDOT trust, the balance of $4,510,000 million in Juan’s estate will be covered by the marital deduction and there will be no estate tax due on his death! This is a total estate tax-savings of $1.8 million at the time of Juan’s death. (Note: upon Valeries death, the principal of $4,510,000 in the QDOT will pass to Juan and Valerie’s children but will be subject to the 40% estate tax unless Valerie is a US Resident and they are able to take advantage of other planning strategies outside the scope of this discussion).

This planning will keep Valerie from having to sell stocks or real estate to come up with the cash for the IRS.  Further, the $4.5 million in the QDOT will be protected from all types of lawsuits– extremely important when the surviving spouse is in an occupation that is a high-risk lawsuit target, such as a physician, financial advisor, entrepreneur, or real estate development and management.

While a Bypass Trust and QDOT are always needed in this situation, more planning may be required.  Because the surviving spouse cannot invade the principal without incurring estate taxes, he/she may have to live off income alone.  For Valerie, this is not a concern because the estate is so large, but for families with smaller estates, this can be difficult for the surviving spouse.

To combat this problem, the couple should establish an Irrevocable Trust to purchase a 1^st-to-die life insurance policy on the U.S. citizen spouse.  In Juan and Valerie’s case, they could use part of the $2.0 million in stocks to purchase a policy that would pay off when Juan dies. If they buy the policy when Juan is 60, it would pay off about 5 to 1 upon Juan’s death if Juan is in good health (about 2.5 to 1 if Juan is 70).  Assuming they use $1,000,000 from the stocks to purchase the policy, this trust will pay out approximately $5 million to Valerie at Juan’s death. Moreover, because the policy is owned by the irrevocable trust, Valerie will owe $0 in estate taxes on the entire $5 million death benefit … and that $5 million is asset-protected as well. As an alternative, Juan is also allowed to gift his non-citizen spouse $149,000 per year without any tax consequence, and Valerie could simply use this gifted money to purchase a policy on Juan’s Life that she owns, and the death benefit would be entirely hers income tax free and without being subject to estate tax at Juan’s death.

In doing this, Juan and Valerie are able to (1) reduce their present estate tax liability by $1.8 million; (2) prevent a fire-sale of their valuable assets; (3) pass $5.49 million to their children estate tax free; (4) provide Valerie with an additional $5 million of death benefits on Juan’s death, and (5) pass an additional $2.7-4.5 million in assets to their children from their QDOT.

The costs of this planning are the insurance policy, any capital gains taxes on any stocks sold to pay for the policy, and the legal fees to institute the plan.  In total, such costs will be slightly more than $1,000,000 if they implement this plan when Juan is 60 – approximately 10% of their assets at the time we start the planning process, and approximately 6.6-7.6-% of the value of the plan’s benefit of $13-15 million in assets that are in the estate when we are finished with the planning process.

The main challenge is creating this type of strategy is finding the experienced advisors who can implement it.  To create a strategy that works for you, these advisors must have a powerful financial modeling program that can forecast your financial condition under all circumstances, taking into account your retirement and estate planning goals.  This is where many attorneys will fail.

Still, though, attorneys are important to this planning and your advisors should have experienced legal counsel at their disposal. In the end, then, the ideal advisors have both financial expertise and quality legal counsel.  These are the ingredients of a sound retirement and estate plan.

The main problem is that the plans that allow for very large (over $50,000) deductions for the owner usually require significant contributions on behalf of the employees as well.  A basic 401(k) offers very little in the way of annual deductions and there are “top-hat” or “top-heavy” rules that threaten your deductions if a certain percentage of the employees don’t participate.

Generally, a defined benefit plan allows for much bigger deductions for business owners who are getting a late start on the retirement planning (or who have lost their plan assets in a divorce or other lawsuit).  For example, a 50 year business owner who makes over $170,000 per year and is just starting to make contributions to a newly- formed defined benefit plan, may make up to $69,500 of tax-deductible contributions per year.  How is this possible?

The Basics of Defined Benefit Plans

Defined Contribution Plans, like 401(k) and profit sharing plans, restrict your contributions but do not put a cap on the potential growth of the plan assets.  Of course, every business owner will have a different amount available in his/her plan at retirement, which depends on the investment results.  Further, there is no guarantee on how much will be available for retirement unless the investments inside the plan are all in guaranteed, fixed investments.

In a defined benefit plan, the amount you will retire with (at a predetermined age) is set based on your salary and year of retirement.  Then, under IRS approved and actuarially reviewed assumption, you are allowed to put money away on a tax-deductible basis to achieve that goal.  Of course, if the plan accounts for 5% growth in your investments and you only get 3%, there will be much less available in retirement to make up for this risk, the government allows you to alter the amount each year, based on the returns on the investments in the previous year.  There is also a possibility that your investments may exceed the assumed rate of return. If that happens, you will not be allowed to deduct as much in annual contributions in future years.  Because of the annual costs of the actuarial review, defined benefit plans are more costly than the defined contribution plan alternatives.  However, if you are over the age of 50 and don’t have much in the way of retirement plan savings, the tax-deductions will more than offset the additional cost of approximately $1,000 per year – not to mention you will be able to save more for your retirement.

A Variation on the Theme – how to deduct $200,000 per year

A 412(I) plan is a type of defined benefit plan.  This plan works almost exactly the same way as the typical defined benefit plan.  However, there is one major twist – the benefit in retirement is Guaranteed!  That’s right.  If you construct a 412(I) plan to give you a monthly benefit of $15,000 per month in retirement, it is guaranteed to be at least that high.  How is this done?

The 412(I) plan purchases a blend of annuities and permanent life insurance from insurance companies that offer guarantees of 2% or 3%.  With a 2% or 3% return guaranteed, the IRS allows you to use the 2% or 3% return in your calculation of future value of the plan.  Because the regular defined benefit plans assume a nonguaranteed return of 5%-7% when determining the amount of tax-deductible contributions the owner can make and the 419(I) plans use a much lower 2%-3% return, the 412(I) plans allow for significantly more in tax-deductible contributions annually.  For example, it is possible for the same 50-year-old business owner mentioned before to make contributions of $85,000 or more per year in a 412(I) plan.

Why would I want lower returns? 

You are not getting lower returns.  You are just guaranteed a lower amount – with the upside potential of greater returns.  The annuities in the 412(I) plan may still give you 5%-7% or more per year.  In fact, the 412(I) plan’s investments will likely give you much more than the 2%-3%.  However, we only have to use the guaranteed amount in our actuarial calculation.  This is what allows some 60-65 year old business owners to make $250,000 in tax-deductible contributions per year into a 412(I) plan.

You are saving significant income taxes in your prime earning years, you are getting a guaranteed return on your investment, you have the upside of the market, and you do NOT have to have any employees to start a 412(I) plan.  We find that many anesthesiologists either work for themselves or work in a larger group and have no employees.  In the latter case, we generally recommend making your own individual Professional Corporation (PC) or Professional Association (PA) a partner or member of the larger group.  Then, you can create the retirement plan that best fits your individual needs.

If you would like us to review your situation and recommend a strategy that best meets your goals, or if you want us to review your existing plan to see if we can help you reduce your annual fees or investment expenses, please do not hesitate to contact me or a local financial planner or life insurance agent.

To avoid the tax burden appreciated assets may create for you, you can use a charitable remainder trust.  You can give appreciated stock to a charity of your choosing and receive a write-off for your donation.  The stock will be sold by the charity with no capital gains taxes paid by either you or the charity.  Then, the charity will reinvest the proceeds in securities or annuities that provide growth and income.  You receive the income annually.  When you pass away, the principal is left to the charity.

The Economics of Charitable Giving Illustrated

Lauryn, a 50 year old orthopedic surgeon, makes $350,000 per year and has $1,000,000 worth of Microsoft stock.  Since she purchased the stock for $200,000, she would have to pay capital gains tax on the $800,000 of gain.  Assuming she pays $160,000 (20%) in capital gains taxes, the stock is only really worth $840,000 to Lauryn.  This $840,000 could then generate $58,800 annually, if you assume a return of 7%.  Assuming a capital gains and dividend tax rate of 20%, Lauryn will pay tax of $12,338 on her investment earnings ($58,800 x 20%). Her net income on her live on the interest strategy would thus be $46,462 ($58,800 – 12,338).

Moreover, assuming Lauryn is in the 40% estate tax bracket and she holds this principal until her death, her estate might incur an estate tax of $336,000 (840,000 x 40%). Hence, the portfolio will only be worth $504,000 (840,000 – 336,000) to her heirs.

If Lauryn gifts the stock to a charity through a charitable remainder trust, she will get a deduction of approximately $282,000 (according to the IRS uniform gift & annuity table) which can be written off against income.  If you assume she pays 40% in state and federal income taxes, this write-off will create approximately $112,800 ($282,000 x 40%) of ordinary income tax savings to Lauryn which may be distributed over a period of six (6) years ($18,800 annually) depending on her adjusted gross income and the type of gift she makes.

Additionally, the $1,000,000 gift creates an annual income from the trust of $80,000 before income taxes ($1 million x 8.0% unitrust interest rate) for Lauryn. Again, assuming an effective tax rate of 25% on these earnings, Lauryn will pay tax of $20,000 per year on her Charitable Trust earnings ($80,000 x 25%), and her net earnings from the Charitable Trust payment will be approximately $60,000 per year net of tax ($80,000 – 20,000). This does not even factor the annual approximate tax savings of $18,800 for the first six (6) years generated by the strategy, as explained in the prior paragraph (Note: the taxation of earnings from a Charitable Trust can vary, and the rate of 25% used in this example is for illustrative purposes only).

 We can see that the charitable gifting option is worth nearly $14,000 more per year to Lauryn than the living on the interest and earnings from investment option, and this occurs apart from the additional $18,800 in ordinary income tax savings generated by the strategy. However, you probably noticed that in the charitable gifting scenario, Lauryn’s heirs will not be left the principal of $840,000 (which will be worth $504,000 after estate taxes of 40% are paid).

Donor’s Heirs Can Be Better off As Well

If Lauryn has an estate tax issue, however, her heirs are actually better off in the “Charitable Gift” scenario as well.  Why?  Because Lauryn took the $60,000 Charitable Trust payment, net of income taxes, and used this payment to purchase a wealth replacement life insurance policy.  Let’s see how this works, assuming Lauryn has a net income of $50,000 per year from her Charitable Trust payment:

Starts with Charitable Trust payment                                     $80,000*
Income Taxes on Charitable Trust Payment                           (20,000)
Trust Legal and Accounting fees per year                                (2,000)
Payment Net of Income Taxes and fees                                  $58,000
Gifts $54,000 per year to ILIT                                                ($54,000)

Purchases life insurance in the ILIT with face value of       $2,500,000
Estate tax due at death                                                                                $0
Amount left to children and grandchildren                            $2,500,000

The entire transaction can be summarized in the table below:

The Trade Off is nearly $46,462 of after-tax annual income and $504,000 to her heirs or $60,000 of after-tax annual income and $2,500,000 to her heirs.  It is an obvious choice.

Of course, this solution can work with many different assets, not just highly appreciated stock.  However, this solution is not ideal for everyone and the IRS has tables which dictate how great the personal benefit can be on a charitable gift.  Further, these estimates are based on current assumptions of taxes, interest rates, and life expectancies.  Each case will be different, but the philosophy is the same, and it can be a very favorable philosophy if done properly.

In this article, we will examine the 5 most significant mistakes people make when creating (or ignoring) their family’s estate plan.  We’ll also cover simple tools that one can use to avoid such mistakes and allow one’s family to elude the unnecessary delays, legal costs, and taxes which come with poor planning.

———-Mistake #1: Losing Money, Time, Privacy, & Control through Probate———-

One of the most prevalent mistakes that we find in our clients’ estate plans is that their estate will end up in the probate courts after they die.  In many states, probate should be avoided at all costs – as attorneys and courts rack up expensive bills, delaying the transfers which your will covered lucidly (or so you thought).  This ties up funds that your heirs may need to pay federal and state estate tax bills.

• Scope of the Problem: Probate Basics

Probate is the process by which a court administers a will.  There are many problems with probate, including the following:

•  Preventative medicine: Use a Living Trust

A Living Trust is a revocable trust, like a will, which you can change or revoke at any time prior to your death. Also, like a will, it dictates how your property should be distributed at your (and your spouse’s) death. However, unlike a will, a Living Trust is a private document and is not subject to the court’s probate process.  Instead, when you die, the successor trustee of your trust simply distributes the property as you designated in the trust document.  There are no long probate delays, court costs, or publicity.

There are numerous other benefits to the Living Trust (see preventative medicine #2 below) including:

• Avoids the unintentional disinheriting risked by joint tenancy.
• Prevents court control of assets if you become incapacitated.
• Can be changed at any time prior to your incapacity or death.
• Can protect dependents with special needs.

The costs of a Living Trust are extremely low, from $3,000 or more depending on the complexity of the situation.  In states where Living Trusts are not used as often, most attorneys use trust-type provisions within wills. These provide the same planning benefits, but would still require that the estate go through the probate process.

—————Mistake #2: Losing Almost Half of Life Insurance Proceeds to Taxes——-

Life insurance is highly recommended as a tool to pay the estate taxes due when you die because the funds will be available immediately to your survivors, without any delays or expenses involved with liquidating tangible assets.  Further, clients who set up policies in advance of their retirement years enjoy powerful leveraging of today’s dollars.  Nonetheless, most people fail to utilize a simple trust which enables all of the insurance proceeds to be estate tax-exempt.

• Why the IRS May Get More Than Half of Your Policy

The greatest misconception most clients have when it comes to life insurance is that the proceeds are paid estate tax free.  This is absolutely wrong!  The proceeds are income tax free but are subject to both federal and state estate taxes.  As explained above, current federal and state estate taxes can swell to 40%. Why lose potentially hundreds of thousands of dollars of your policy proceeds after you paid those premiums so diligently … especially when a simple trust can take the IRS out of the pictures and provide better protection for your beneficiaries? Ho

• Preventative Medicine: Using Irrevocable Life Insurance Trusts (ILITs)

An irrevocable life insurance trust (ILIT) is simply an irrevocable trust which owns a life insurance policy. The ILIT saves you estate taxes because it, rather than you personally, owns the life insurance policy.  Because the policy is not owned in your name, the policy proceeds will not be part of your net estate when you die (as long as you survive 3 years from the transfer to the trust).  Thus, the proceeds will not be subject to the estate tax.  This can save your family a great deal of money.

• ILITs Give You Control

The ILIT gives you much more control over what happens to the policy proceeds than you would get from a bare insurance policy.  With an insurance policy alone, your only decision is to whom you will leave the proceeds (the beneficiaries) — the insurance company will simply pay these people when you die pursuant to a very limited set of settlement or payment options.

With an ILIT, on the other hand, you can control not only who gets the proceeds and exactly what happens to the funds when you die. You can have the trustee pay the beneficiaries directly or pay them over a period of months or years.  You can incorporate spendthrift provisions and anti-alienation provisions to protect against your beneficiary’s (children’s) financial problems or their spouse’s financial woes.  In fact, an ILIT gives you all of the benefits of a trust arrangement — while allowing you to provide for your family just as you would with a bare insurance policy.

For these reasons, an ILIT should be used to own almost every life insurance policy in a client’s estate plan.

Note:  If you have already purchased a life insurance policy or are presently making payments on an existing policy, it is not too late. You can always transfer a policy to an ILIT.  There may be some gift-tax issues associated with this maneuver, but they will be very minor compared to the large tax savings your family will ultimately enjoy.

———————-Mistake #3: Leaving Property to the IRS———————

While no person leaves property to the IRS intentionally, quite often this is the effect of a person’s estate if he/she has not implemented a gifting program during his or her lifetime.  Simply put, after the exemption amount, any property not given away “in title” during your lifetime will be taken in part by Uncle Sam.  To prevent this – along with the strategies explained above – clients can gift property to family members.

Most clients initially hesitate to begin a gifting program, as they think they will have to give up control of the underlying assets.  As you’ll see below, this is not true.  Instead, one can use legal entities to remove asset values from one’s estate, while maintaining 100% control of the assets while one is alive.

• Preventative Medicine: Gifting Using FLPs and FLLCs

Through entities like family limited partnerships (FLPs) and family limited liability companies (FLLCs), you can share ownership with family members … yet maintain control. In this strategy, you and your spouse gift ownership interests to children over time (using your combined annual $28,000 per donee gift tax exclusion), removing those interests from your estates for tax purposes.  Still, as long as you and your spouse are the FLP general partners or LLC managers, you will maintain control of the underlying assets. Let’s examine a case study:

Case Study: Robert’s Mutual Funds

Robert Jones and his wife, both age 60 and the parents of 5 children, owned $4 million in mutual funds, and $10 million in real estate assets. They set up an FLP to own the mutual funds and real estate, naming themselves the managing general partners. They initially owned 99% of the partnership interests, gifting 1% to their five children. Since the 1% was worth approximately $140,000 ($28,000 per child), the gifts to the children were tax-free.  NOTE: a common practice, known as “discounting,” may allow you to gift up to $20,000/year (possibly more) to each child or beneficiary ($40,000/year if you are married) without having to pay any gift taxes.

Robert can continue to gift these children $140,000 in FLP interests each year, completely tax-free. If Robert lives to age 85, he will give $3,500,000 in FLP interests to his children ($700,000 each), tax-free. This $3,500,000 will no longer be in his estate, and not subject to estate tax. Because Robert’s other assets put him in the 40% estate tax bracket, his estate tax savings using the FLP will be $1,400,000 (40% x $3,500,000). Because he is the FLP’s sole general partner, Robert completely controls the mutual fund and real estate portfolios while alive and can distribute the income to himself or sell some of the funds for his expenses. Robert maintains control of his assets for his lifetime, pays less estate tax, and also provides more for his children.

—-Mistake #4: Losing 80%+ of Pensions, 401(k)s, and IRAs to Taxes Unnecessarily—

Would you be surprised to know that the vast majority of the funds in pensions, 401(k)s, and IRAs will end up with state and federal tax agencies?  Did you think that – after paying taxes for a lifetime of work – your “tax qualified” retirement plans could be taxed at rates from between 60-70%?  Most people – when hearing these facts – are shocked, appalled, and want to learn how to do something about it. While the details of such techniques are beyond the scope of this article, suffice it to so say here that – with advanced planning – the threat of taxes decimating a qualified plan can be eliminated.

Conclusion

Many otherwise-sophisticated clients put their families in an estate planning mess because of the mistakes covered above.  Clients with larger estates have even more potential pitfalls to avoid in their planning.  Thus, this article’s true purpose is to serve as an “eye opener.”  While educating oneself as to the potential errors in the estate planning arena is important – as in medicine – there is no substitute for consults with a licensed professional experienced in these matters.  In this way, an estate planning “physical” is the real first step in any worthwhile estate plan.

Glenn M. Terrones is a Los Angeles attorney who practices in the areas of Estate Planning, Income Tax Planning, and Asset Protection. He is the co-author of Wealth Protection, M.D. and Financial Secrets to Franchising Success, as well as several articles on the topics of asset protection, estate planning, and income tax planning. If you would like to contact him, he can be reached at (818) 649-7673 or by email at glenn@terroneslaw.com.