Wealth Preservation: Five Strategies

By Stephen D. Lassar, Mark W. McGorry, and Craig W. McGorry

In Brief

Wealth Planning Opportunities

Practical approaches to solving frequently encountered financial planning and tax problems are always in demand. The authors present solutions that use testamentary and inter vivos tools for distinctly different pre- and postmortem fact situations involving significant wealth accumulation in IRAs, qualified plans (including ESOPs), tax-deferred annuities, and Roth IRAs. The facts and circumstances of five cases provide real examples of wealth planning opportunities.

Case 1

Taxpayer A is a recently widowed 73-year-old whose personal residence was destroyed by fire. Due to underinsurance, A incurred a net loss of approximately $130,000, which is tax deductible each year up to the casualty loss formula limitation. Among other financial assets, A owns a regular IRA.

Objective. Optimize wealth accumulation by extending the IRA’s minimum required distribution (MRD) period to that of A’s intended legatees with the greatest income tax efficiency possible.

Analysis and recommendation. Convert a portion of the existing IRA to a Roth IRA and use the casualty loss deduction to offset the gross income inclusion requirement for conversions from regular IRAs to Roth IRAs.

The benefits of this strategy to A and her heirs include the following:

Case 2

Taxpayer B is the sole shareholder of a C corporation that has substantial profits that are likely to continue in the near future. This business constitutes most of B’s net worth. B’s tax advisers believe that B’s salary and performance-based bonus currently constitute “reasonable compensation” for tax purposes, but could be viewed as unreasonable if increased significantly. The tax advisers have considered a change to S corporation status so that corporate profits would be taxed only once, whether retained by the business or distributed to B. Although there is currently no plan to sell the business, several potential buyers have indicated a strong interest.

The corporation also sponsors a 401(k) plan, which provides for employee elective contributions and matching contributions by the employer.

Objective. Eliminate double taxation of corporation profits in a tax-efficient manner and diversify B’s investments beyond this closely held business.

Analysis and recommendation. Create an employee stock ownership plan (ESOP) and have B sell a portion or all of his stock to the ESOP in a transaction qualifying for nonrecognition of gain under IRC section 1042. ESOPs can provide a capital gain deferral to the selling owner and create wealth for the employees, who are also ESOP participants, without any current income tax recognition.

Once an ESOP has been formed, the corporation would borrow money from an independent financial institution and lend the proceeds to the ESOP on arm’s-length terms. The ESOP would pay for the stock with the loan proceeds and repay the loan principal and interest from tax-deductible contributions received annually from the C corporation.

In general, a corporation is allowed tax-deductible contributions to a leveraged ESOP equal to 25% of “covered compensation” to repay loan principal, in addition to the interest payouts on the loan. Prior to 2002, the elective contributions by the employees to the 401(k) plan were taken into account when determining the maximum deduction allowed to the plan sponsor each year. Under the 2001 Tax Act (effective for plan years beginning on or after January 1, 2002), elective contributions are deductible without regard to the 25% maximum deduction limit that applies to defined contribution plans. Therefore the 401(k) elective contributions will be fully deductible even if the ESOP is funded for the maximum allowed under the law. However, because the sponsoring corporation will not be able to deduct the matching portion of the 401(k)—to the extent the ESOP contribution (excluding loan interest) exceeds 25% of covered compensation—the match is being eliminated.

The gain on B’s sale of stock to the ESOP will be recognized either as a net capital gain at the favorable tax rate or deferred under the provisions of IRC section 1042. If the transaction qualifies under IRC section 1042, gain will not be currently recognized as long as the seller makes a section 1042 election, purchases qualified securities during the replacement period, and satisfies the other requirements of IRC section 1042(b). Under IRC section 1042, only C corporation stock is eligible for tax deferral of gain. This deferral does not apply to the sale of S corporation stock to an ESOP.

The ESOP allows B to create substantial wealth separate from the business without current taxation of the gain from the stock sale. Annual contributions to the ESOP will reduce corporate profits consistent with the goal of corporate tax reduction. In addition, retaining a significant ownership in the corporation allows B to continue to share in any appreciation of the business.

Case 3

Taxpayers C and D are a husband and wife in their mid-60s who need life insurance as part of their overall estate plan. They have significant assets in both real estate and a closely held business, as well as assets in C’s profit-sharing account.

Objective. To provide cash to pay estate taxes on the value of an estate composed primarily of illiquid assets.

Analysis and recommendation. The qualified plan and IRA assets total more than $2 million, but are a relatively small part of the estate. The rest of the estate consists primarily of closely held business interests, including investment real estate.

In this case, D agreed to waive her rights to inherit the assets in the profit-sharing plan and executed the appropriate spousal waiver. C’s children were named as beneficiaries of the profit-sharing plan. These steps provided enough flexibility for post–first death planning. If circumstances were to allow it, a person other than the insured could acquire the policy after the first death or while both are living, bypassing the estate tax on the death benefit. (A careful review is necessary to comply with the “prohibited-transaction” rules associated with qualified plans and the “transfer-for-value” rules, which might subject the insurance policy to income taxes upon death of the insured.)

This strategy allows C to use pretax qualified plan assets to satisfy life insurance needs, while minimizing income and gift taxes. This approach should be part of an overall estate plan that includes transferring other assets to intended beneficiaries. It is usually most effective when assets pass directly or indirectly to the intended beneficiaries substantially in advance of expected increases in value. This places the heirs in the position of having access to money (plan assets) that can be used as part of an exit strategy, either during both their lifetimes, or after the first death.

Case 4

Taxpayer E, an 85-year-old woman, passed away in 2001, leaving her 55-year-old daughter F as the sole non-charitable beneficiary. Both E and F have been charitably inclined, which provides special opportunities for income, gift, and estate tax planning.

Objective. To minimize estate taxes and provide supplemental income for the beneficiary, F, during her working years and income for her retirement.

Analysis. The value of the estate was approximately $4.5 million, consisting of an IRA, tax-deferred variable annuities, and step-up-in-basis assets. In addition, during her lifetime, E had created a net-income makeup charitable remainder trust (NIMCRUT) with F designated as the sole income beneficiary for the remainder of her life. It also provided a charitable deduction for E in the year of the transfer and reduced the value of the taxable gift to her daughter. F has the right to a substantial amount of undistributed unitrust income, which will be paid to her in the future.

Recommendation. F should make qualified disclaimers, which would cause the estate assets to be placed in a testamentary charitable lead annuity trust (CLAT).

The decedent’s estate planning team provided for a CLAT in E’s will. Any significant funding of the testamentary CLAT would be accomplished through postmortem disclaimers by the daughter of her interest in property that was jointly held or passed to her under beneficiary arrangements. The initial funding of the CLAT under this strategy is approximately $2.8 million.

It was calculated that, based on the applicable federal rate (AFR) and assuming an 8% charitable lead interest for 10 years, the charitable deduction to the estate was equal to about 65% of the assets transferred to the CLAT.

It was decided not to disclaim F’s interest in her mother’s IRA but to instead receive it as the stated beneficiary. This would provide her with the benefits of the “stretch-out” on the taxable distributions from the IRA. One of the IRA assets was in the form of a variable annuity which provided a substantial guaranteed minimum death benefit in the midst of the worst bear market in more than a generation.

Advance planning provided the opportunity for the qualified disclaimers, which led to tax benefits of approximately $1 million. This strategy was effective not only because of the structure of the will, which included a testamentary CLAT and an appropriate estate tax apportionment clause, but also because a charitable remainder trust (CRT) was created during E’s lifetime for the benefit of the daughter. Because the CRT provides supplemental income to the daughter, she is able to forgo income from the testamentary CLAT for the next 10 years.

Case 5

Taxpayer G is a recently widowed 68-year-old New York State resident. Her assets included two income-in-respect-of-a-decedent accounts: an IRA, and a tax-deferred variable annuity (which had been owned by G’s husband) with a very large tax-deferred gain.

Objective. To provide a steady source of income to G while minimizing income taxes, and to minimize IRA distributions in order to maximize income tax deferral during G’s life and ultimately for the benefit of her heirs.

Analysis and recommendation. G should annuitize her deceased husband’s existing tax-deferred variable annuity. Variable annuities have two unique features that make them ideal candidates for long-term savings: All gain is tax-deferred until withdrawn by the owner or the beneficiary, and a death benefit assures the beneficiary that at least the initial deposit, adjusted for withdrawals, will be available at death.

Similar to an IRA, any tax-deferred growth will be taxable as ordinary income when received by the owner or the beneficiary. Like an IRA, spreading the distribution over many years can mitigate the tax impact and take advantage of potentially lower marginal rates.

Death benefit guarantees can vary substantially from contract to contract. The most basic feature provides a death benefit of the greater of the accumulated value upon death or the cumulative deposits to the contract. G’s husband’s contract had an enhanced death benefit guarantee, which provided that the death benefit is the greater of the market value or the guaranteed death benefit calculated by increasing the original deposit on each anniversary by 7%, adjusted for any partial withdrawals.

Because of this enhanced death benefit, the guaranteed amount was significantly greater than the market value of the contract. G’s husband initially deposited $830,000 in the annuity contact. During the two and a half years preceding his death, the fair market value had fallen by approximately 40% to $500,000. Because of the minimum death benefit guarantee, however, the death benefit to G was $975,000. If the portfolio had been comprised of individual stocks or mutual funds rather than a guaranteed death benefit annuity with mutual fund subaccounts, the portfolio’s value at death would have been significantly reduced.

G had three choices under the annuity contract:

Planning for future income needs. In the last several years, annuity contracts have been developed that offer lifetime benefits similar to the annuity death benefits described above. In this case, a new annuity was purchased with cash that G inherited from her husband. Under this additional contract, G can annuitize the contract (i.e., begin receiving payments) seven years or more from the initial purchase date under terms that provide an income-floor guarantee based on the greater of either the accumulated value when payments begin or the initial deposit increased by 6% per year until annuitization begins.

During the deferral period, G can choose her investments from a multitude of equity or bond subaccounts and can reallocate or rebalance them without tax consequences. Under this arrangement, G can make a single deposit today that will guarantee her a lifetime annuity, beginning in seven years, of no less than the same $155,000 she would receive from annuitizing the amount due under her husband’s annuity guaranteed death benefit. If annuitizing the fair market value of her inside investments at the time she decides to annuitize offers a higher yearly income, G can elect that option. She would also be free to engage in an IRC section 1035 tax-deferred exchange for another annuity contract if that offers a more competitive income stream. Approximately one-half of the income stream would be treated as a tax-free return of capital.

By using these strategies to meet her cash flow needs on a partially tax-free basis, G can limit her IRA distribution to the minimum required. As a result, G can allow the IRA to grow over the long term and provide a greater financial legacy for her children and grandchildren.

©2002 CPA Journal. Legal Notices