Posted Tuesday, August 10, 2021

One of our primary focuses at WCG is ensuring you are paying the least amount of taxes allowed by law. Some of our other primary focuses are helping you build wealth and leverage the most of your financial worlds for you and your family. However, these focuses or objectives are not isolated; they are very much related to each other and intertwined.

Before we run through several tax reduction and tax avoidance ideas, let’s talk about some basic concepts-

There is not a secret tax deduction club that only a few people know about. If there were, it would be like fight club, right? But trust us when we say no one not is talking about a tax deduction club intentionally.

Most people are interested in saving cash when they say they want to reduce or avoid taxes, but saving cash and reducing taxes are not necessarily the same.

Two households, making the exact same income, might have wildly different tax liabilities based on the myriad of variables such as children, mortgage interest, charitable donations, available tax credits, and, Yes, the proficiency of the tax professionals involved.

As household incomes travel through the ranges, a lot of things happen. The first $100,000 in income for most households is well-sheltered with itemized deductions and low tax brackets. The next $100,000 in income sees certain tax credits go away, higher tax brackets and fewer available tax deductions such as IRAs and other things (what we call income phase-outs). In other words, if you go from $100,000 to $200,000 in household income, you will pay way more than double in taxes (you could easily see 2.5 to 3.0 times more). Yuck! The next $100,000 and beyond is completely naked, and is generally purely taxable (unless some tax reduction tactics are deployed). Super yuck!

Tax deductions and tax deferrals are not the same. Tax deferrals are tax bombs later in life; little IOU’s to the IRS and they will eventually call in the chit. But if you use the immediate tax savings to build wealth, then a tax deferral is worth it. Deferring taxes to pay for a cruise vacation might not always be the best approach (then again, live a little!).

You want to match the highest tax deduction to the high income. Let’s say it’s December and you are considering buying a piece of equipment. If next year’s income is going to be significantly higher, wouldn’t it make sense to wait until January to complete the purchase? Probably.

Tax deductions commonly need separation with cash. For example, you can save $2,500 (for example) in taxes right now if you write a check for $10,000 to a charity. That might not make sense if you are more interested in cash than taxes, right? Tax deferrals commonly need separation with cash as well, but at least you get it back. IRA’s and 401k plans (among others) come to mind.

Ok, here we go on those tax reduction and tax avoidance tactics-

Cost: Zero
Funding: NA
Tax Complexity: Bunny Hill

You sell securities whose price is stable yet is lower than what you paid. You use these losses to reduce the capital gains on securities you sold previously (profit harvesting). You wait 30 days to prevent wash sale triggers and re-purchase the securities that were sold at a loss (only if you believe it will eventually rebound in a timeframe that makes sense given inflation and other economic conditions).

Cost: Interest Cost of Loan
Funding: NA, but need to have securities with unrealized gains
Tax Complexity: Green

There was chatter about taxing unrealized gains on stocks and other securities. Why? First, what are unrealized gains? These are “paper” gains where you buy a stock for $10 and it is now worth $100, but you haven’t sold it yet. What is the big deal?

Well… let’s say you bought a bunch of Tesla stock in 2017 for $47 and now it is worth $1,000 a share. You have about $950 in unrealized gains per share. Let’s also say you invested $50,000 into Tesla stock back in 2017 and you now have around $1 million. If you sold this stock to grab the cash, you would pay capital gains taxes on $950,000 or about $170,000ish in taxes.

But can you grab some cash without paying taxes? Yes! You could easily borrow up to 50% (or higher depending on your situation) of the stock’s value or about $500,000 in this example. In speaking with a Morgan Stanley financial advisor recently, they would lend up to 60% on Tesla stock and charge interest only payments at LIBOR (right around 2.5% for the past few years). So… you grab $600,000 in this example, pay 2.5% interest rate, and buy a rental or buy another investment (there are some rules here). You still own the Tesla stock. You probably can find a rate of return on the borrowed funds that exceeds LIBOR. Win win!

There is some risk should the stock decline since you will need to reduce your loan with cash.

Now you know why there was chatter about taxing unrealized gains since people are “converting” into cash for their benefit without paying taxes.

Cost: Zero
Funding: NA, Money is Already Spent
Tax Complexity: Green Circle

You review money that has already been spent such as automobiles, travel, meals, etc. and determine if a business connection existed (or for future money spent, if a business connection will exist). The theory here is to take money that is already budgeted to be spent and try to find a business connection (ordinary and necessary) and therefore a tax deduction. A wonderful example is purchasing a new car because you need one, and also being able to support a 100% business use of that car for a big fat tax deduction.

Cost: Zero
Funding: Same as IRA and 401k
Tax Complexity: Green Circle

California tops the list of highest tax rates at 13.3%, with Hawaii at 11%, New Jersey at 10.75% and Oregon at 9.9% rounding out the top four. If you can defer taxes through an IRA or 401k contribution for several years, and then retire in a lower income tax state, you can convert your income tax deferral into tax avoidance. In other words, you reduce your taxable income in California and then when you retire you establish residency elsewhere like Nevada.

Pennsylvania among a few other states, however, does not honor the federal tax deferral of a 401k contribution. Therefore, when preparing a Pennsylvania tax return, pre-tax 401k contributions are added back to your income to arrive at taxable income. Yuck.

Besides the income tax free states (AK, WA, NV, WY, SD, TX, TN, FL and NH) some states do not tax your 401k, IRA and pension income during retirement. Illinois, Mississippi and our friend Pennsylvania. Some states, such as Colorado, only tax amounts over a certain exclusion amount. Keep this in mind as you plan your wage earning state versus your retirement state.

Cost: Zero, Perhaps $500 for a Solo 401k Plan
Funding: Varies, Money is Restricted
Tax Complexity: Bunny Hill

You contribute to a qualified account or plan, and your taxable income is reduced. Taxes are paid when funds are distributed, but perhaps at a lower tax rate. Also, the tax savings today can be leveraged into other investments helping build wealth.

Cost: $4,000 to $6,000 Annually, Plus Additional Payroll Taxes on High Compensation
Funding: $100,000 to $150,000 Annually for 3-5 Years
Tax Complexity: Bunny Hill

A third-party administrator and actuary design a self-funded pension plan that usually (but not always) is piggybacked onto a 401k plan with a profit-sharing plan. It requires significant cash for a period of 3-5 years, and is generally very difficult to pause or stop without risk.

Cost: Varies
Funding: Varies, Money is Restricted
Tax Complexity: Green Circle

An important tax reduction option is the Roth IRA—a truly remarkable vehicle which allows you to pay taxes today, but then create a tax-free investment fund for the rest of your life. A simple rule to consider is that most investments double every 9-10 years, and with a Roth IRA this increase is tax-free.

You can also convert traditional IRA’s into Roth IRA’s. This creates a taxable event today but allows for tax-free growth. Conversions should be planned carefully, and are especially beneficial during low income years.

Cost: $1,500 Tax Preparation plus $500 to $700 Plan Administration
Funding: NA, Money is Shifted
Tax Complexity: Blue Square

A C corporation is not deemed to be a pass-through entity and therefore has additional flexibility in providing certain health-related benefits without being considered taxable fringe benefits to the owners. Another entity (for example, an S Corp) pays a management fee to the C Corp. The C Corp in turn uses the revenue to pay for certain health-related benefits and reimbursements. About $6,000 or more in health-related benefits must be paid for this arrangement to break-even. IRS risk is moderate since the business connection between the S Corp and the C Corp might not be arms-length or in good faith.

Cost: $3,000 to $6,000
Funding: Varies, Depends on the Purchase Price (at least $750,000)
Tax Complexity: Blue Square (no bumps)

You are purchasing real estate property for business or rental use. Typically, the entire purchase price less the portion attributable to land is depreciated over 27.5 or 39.0 years. With a cost-segregation report, certain asset classes are established with varying depreciation schedules, and allow for certain parts of the building to have accelerated depreciation. All the bricks are figuratively torn down, put in different piles, labeled as such, and then re-assembled.

This works well when there is existing rental income or tax basis in the entity to allow for temporarily inflated tax losses through depreciation. If you are limited by passive-loss limitations because of your income, then a Real Estate Professional designation would need to be explored. In other words, unless you have net rental income or you are not limited by passive activity loss limits, then the accelerated deprecation from a cost segregation study will not provide the impact worth the cost.

Cost: $500 for Form 3115, and Slight Increase in Tax Preparation Fees ($250 to $500)
Funding: NA
Tax Complexity: Green Circle

Accrual accounting allows for risk-based reductions in income recognition. For example, a commercial real estate broker typically has a clawback provision should a lease break before its term. Let’s say a real estate broker can safely demonstrate that 30% of the deals will breach and cash will be returned to the landlord (the clawback). In accrual accounting, a portion of the cash received could be classified as Unearned Revenue and therefore not taxed until it is earned (i.e., the risk of clawback on a portion of earnings has passed). But you still have the cash, which is king.

Cost: Increased Unemployment Taxes ($350 to $600)
Funding: NA, Money is Shifted (overall officer compensation remains the same)
Tax Complexity: Green Circle

By identifying your spouse as an officer and paying a salary, certain meals might be become business meals. He or she can join the primary business owner on business travel. The theory is similar to the Budget Review example where money that is already budgeted to be spent is now seen as having a business connection. Generally, you need $2,000 or more in increased business expenses to be worthwhile. And Yes, they have to work.

Cost: Social Security and Medicare Taxes at 15.3%
Funding: $12,600 per Child
Tax Complexity: Blue Square (no bumps)

You pay your child $12,600 or whatever the standard deduction is for that tax year and they spend it on college or gift the money back to you (or they fund a Roth IRA and save the rest for their first home). This is a deduction to you at your tax rate but is tax-free to the child. However, the child pays 7.65% in Social Security and Medicare taxes and the S Corp pays the same. Additionally, the parents might lose child tax credits. Therefore, this usually works well when the parents tax rate is 32% or higher to provide a large enough delta between 15.3% (mandatory payroll taxes) and the parent’s tax rate plus tax credit considerations. And Yes, they have to work (since chores are a snap, why not have them work too).

Cost: $1,200 Annual Payroll Processing Fees plus $300 Additional Tax Prep Fees
Funding: $12,600 per Child
Tax Complexity: Blue Square

Similar to above, however, the S Corp pays a management fee to another LLC that is reported on Schedule C of Form 1040 (not an S Corp). Since this garden-variety LLC is not an S Corp, Social Security and Medicare taxes do not have to be paid on wages to children. $9,800 must be paid to the child(ren) to break-even on the costs. IRS risk is moderate since the business connection between the S Corp and the Family Management LLC might not be arms-length or in good faith.

Cost: Zero
Funding: NA, Money is Not Restricted
Tax Complexity: Blue Circle

You find a business connection for renting space in your home for 14 days or fewer. Client parties and presentations are good examples. Board meetings for closely held businesses is a bad example (or at least one that is tough to defend). Your business enters into a lease arrangement at market rates. The business deducts the amounts paid as rent and issues a 1099 to you. On your tax return, the amount of rent is reduced to zero with a one-time expense under Section 280A in the amount of rent.

Cost: Low
Funding: Varies
Tax Complexity: Green Circle

You donate significant assets such as cash or securities or both to a donor advised fund. You get an immediate tax deduction for the fair market value, but those assets are not immediately donated to any one charity. This allows for two wonderful things; first, playing on the matching principle mentioned at the beginning of this article, you can make a massive donation during a uniquely high-income year. Second, you can then take your tax-deducted donation, and spread it out over multiple years while enjoying the tax benefit now.

Here is another consideration- let’s say your itemized deduction add up to $15,900 yet the standard deduction is $25,900 (for the 2022 tax year)… or a difference of $10,000. You could donate $10,000 each year with no additional tax benefit (Yes, the state might give some) since you would be using the standard deduction versus an itemized deduction ($25,900 vs. $15,900). Do this for 10 years… and your $100,000 does not move the tax needle.

But! You donate a $100,000 to a donor advised fund, you get $90,000 at your marginal tax rate as cash in pocket ($90,000 x 24% is $21,600 in cash). You still get the itemized deduction bump of $10,000 to arrive at the standard deduction for 9 more years, your charity gets $10,000 each year as desired, and you are $21,600 richer. Real money, folks!

Tax planning for $400 please, Aaron. Yes, it’s a daily double!

Cost: Varies, Could be Significant
Funding: Varies, Usually $25,000 or Higher
Tax Complexity: Terrain Park, Target IRS Audits and Challenges (some are abusive tax shelters)

You find a piece of land or some other donatable property. You purchase it for $25,000 (for example), however, an appraisal opines a fair market value of $150,000. Your tax rate is 37% and as such you deduct $150,000 which creates a reduction in taxes of $55,500. You might pay $5,000 in fees, so your overall savings is about $25,000 cash in pocket.

Cost: Very High
Funding: Very High ($1.2M in premiums), Money is Restricted
Tax Complexity: Terrain Park

You start an insurance company and identify a handful of insurance risks that the captive insurance company will insure. Employee theft, business continuance, professional liability, among many others. Life insurance should be avoided. The premium of $1.2M is deducted by the operating company but is not considered income to the captive insurance company. Taxes are paid, however, on the investment income within the captive insurance company. Eventually the money is returned to you at dividend tax rates.

Tax savings is difference between ordinary income tax rates and capital gains tax rates.

Cost: Varies, Usually Small for 1031 Intermediaries
Funding: Money is Restricted
Tax Complexity: Green Square

When you sell a property, you can invoke Section 1031 of the Internal Revenue Code to fully defer your capital gains tax including taxes associated with depreciation recapture, as long as you buy another similar property within 6 months. This is also called a like-kind exchange.

Do this right, and you can daisy-chain transactions to avoid capital gains on real estate through your entire life, while enjoying the benefits of larger and larger incomes (the assumption is that you “1031” into larger investments with better cashflow, etc.). To top it off, your heirs still get a full step up in basis under current tax law.

Cost: Varies
Funding: Varies, Money is Restricted
Tax Complexity: Blue Circle

Retirement accounts are only one way to create tax-advantaged investments; the relationship between permanent life insurance policies and taxes can be a good one. You can use a well-constructed policy to sock away cash and let it grow tax-free, then take carefully planned loans from the policy tax-free, and pass the benefit along to your heirs tax-free over the course of a lifetime. The issues are complex (for example, insurance benefits may be subject to estate taxes but not income taxes), the timeframes are long, and you need professional help to do this right. Yet, insurance remains a powerful tax-avoidance tool.

Cost: Varies, Attorneys and Valuations Are Needed
Funding: Varies, Money is Restricted
Tax Complexity: Terrain Park

Basic valuation theory has two discounts. A discount for lack of control suggests that a minority interest in a business is worth less than the pure ownership percentage. For example, owning 10% of a business worth $500,000 as a whole might be realistically worth $30,000 (versus $50,000). Another discount is lack of marketability which suggests that an interest or a share of a closely held business is not easily convertible to cash.

Another way to look at this; if you take Van Gogh’s Portrait du Docteur Gachet and tear it up into 33 pieces, each piece is worth $0. You put them back together, and you now have a $75,000,000 painting (1990).

So the practice goes like this. You gift 3% of your $25,000,000 business to your heirs. A valuator determines that because of discounts for lack of control (DLOC) and discounts for lack of marketability (DLOM), the 3% is only worth $300,000 instead of strict $25,000,000 x 3% or $750,000. No gift tax is paid since Mom and Dad use a part of their lifetime exclusion.

When all the 3%’s are re-assembled on the back-end, the collection is now worth $25,000,000. Transferred all tax-free.

Cost: Varies, Attorneys and Valuations Are Needed
Funding: Varies, Money is Restricted
Tax Complexity: Terrain Park

This involves basic valuation and discounting theory as the Family Limited Partnership stuff previously. You have a fully self-directed IRA that owns non-publicly traded securities and interests such as partnerships. Because you lack control (minority interest) and lack marketability (restricted on who you can sell to, and there is not a market), your investment is devalued. It goes like this; you buy a $1,000,000 partnership interest. You hire a valuator to determine the value on December 31 for the completion of Form 5498. The valuator applies appropriate discounts and determines the fair market value is $600,000. Next, you perform a Roth conversion, pay taxes on the $600,000 and save nearly $150,000 in taxes on the discount amount of $400,000.

Cost: Expensive
Funding: Varies, Money is Restricted
Tax Complexity: Black Diamond

These are three variations on a common strategy for the intergenerational sharing of wealth to avoid or reduce taxes. A GRAT is a Grantor Retained Annuity Trust. It is created when a grantor contributes assets with appreciation potential to a fixed-term, irrevocable trust. The grantor then retains the right to receive an annuity stream over the trust’s term. At the end of the term, the assets are distributed to noncharitable beneficiaries — typically, the grantor’s children.

A GRIT is not something made from corn but rather is a Grantor Retained Income Trust. It is similar to a GRAT, but spouses, children and other family members cannot be beneficiaries. Since the Revenue Reconciliation Act of 1990, the use of GRITs is very limited.

A Private Annuity is an agreement where an individual transfers property to an “Obligor” (probably your child), and the Obligor agrees to make payments to the “Obligee” (which is the annuitant, i.e., you) on an agreed schedule. A Private Annuity makes sense when the underlying asset is expected to increase in value, and avoids both gift taxes and estate taxes.

All three of these variants assume an expected large growth in asset value while the asset also pays out an income. This stuff is very tricky, has rules and limitations (shocker) and requires a skilled estate planning attorney.

Not sure where to go with all these tax reduction strategies? Let’s chat!

WCG is a full service consultation and tax preparation firm, and we look forward to working with you!