Defy Logic and Save on Taxes

Steve Parrish, Contributor for Forbes: “It’s a tax idea; it doesn’t have to make sense!” This is what I told a business owner recently when he challenged the logic of a tax strategy I suggested. There are all kinds of tax related rules that, to the untrained ear, sound like sheer foolishness. In the right context, however, these ideas make good planning logic for business owners. Below are three examples. Please note: before you embrace the bizarre, be sure to talk to your own tax advisor to see if, indeed, the nonsensical makes sense in your particular situation.

Sure you can defer the tax, but better to pay it now

There are several ways to defer income tax. In the current tax environment, it may make sense to go ahead and pay the tax now, even though you could defer it later. For example, many real estate investors are selling appreciated property and recognizing the income at the time of sale, rather than deferring the gain through a 1031 “like kind exchange.” The rational is that capital gains this year are 15%, while capital gains next year are likely to be 23.8%. We see this with other ideas such as employee stock ownership plans (ESOP). In some cases, a business owner can sell the company stock to the company’s own qualified plan (an ESOP), and defer the gain in the process. It’s not uncommon to see cases where the business owner ignores the deferral opportunity in order to pay the tax at the lower current rate and be done with it.

Tax diversification can trump tax deductible

I don’t think I’ve ever heard a business owner say he or she doesn’t want to reduce taxes. That’s a given. The question, however, is often asked in the form of “but, is it tax deductible?” Income tax rules, in particular, are well defined and there are only so many tax deductions allowed which don’t involve shackles and jail time. Fortunately, immediate tax deductions aren’t the only way to win in the tax savings game.

Most investors subscribe to the idea of “diversification of assets.” An equally sound principle is “diversification of taxes.” Immediate deductions are great, but there are often strings attached. For example, qualified plans are typically tax deductible to the company and  tax-deferred to the employee. The challenge is that eventually the employee has to pay ordinary income tax on that pension income, and the tax basis of a qualified plan portfolio doesn’t step up at death. A good strategy for retirement income savings is to mix the portfolio with qualified plans and other, after-tax vehicles.  Spreading out the tax events allows for significant diversification from a cash flow standpoint.

Take, for example, cash value life insurance. Some business owners are supplementing their future retirement income, and protecting their families, by placing after-tax dollars into cash value life insurance policies on their lives. The cash values builds up tax-deferred, and, one way or another, the proceeds can effectively come out tax-free. The less pleasant way is to have the insurance paid out as a death benefit upon the owner’s death. The preferable way is not to die, and instead, start accessing the cash values at retirement.  If properly structured, the owner can first recover the tax basis of the life insurance tax-free, and then switch to internal policy loans, which are also not currently taxable. Essentially the owner is borrowing against his or her death benefit to reap a tax-free retirement income.

Give the asset away, but keep paying tax on it

Mitt Romney has moved a huge amount of stock to his future heirs in a way that avoids a significant amount of gift and estate tax. A popular technique for wealthy individuals has been to use what is commonly referred to as a “defective grantor” trust. The idea is to gift company stock to an irrevocable trust. Under the current law, you would receive significant discounts in the stock valuation due to minority interests and lack of marketability if discounts are warranted by a certified appraiser. This reduces gift tax exposure. Then, using carefully drafted language, the trust can be structured to be outside the grantor’s estate for federal estate tax purposes, yet have the income from the trust still taxable to the grantor. Why would anyone want to do that? Simply because this technique makes for one more way to avoid gift taxes; in essence, the grantor pays the trust’s taxes, just another “gift” to the beneficiary.

Take the example of Mitt Romney. Even though a trust now owns the stock he gifted, he pays the income tax on income generated by the trust’s assets. Romney’s reported tax rate in 2010 was less than 15%, and that rate is very likely lower than the trust’s tax rate. Further, every dollar of tax that Mr. Romney pays is one less dollar the trust pays; therefore, more money going to the heirs. Finally, every dollar he pays towards income tax is one less dollar that will be subjected to federal estate tax when he dies. The bottom line is that someone — or some entity — has to pay the income tax. It might as well be the wealthy grantor; that way the income isn’t taxed twice — once as income and then as an estate asset.

EXACT CPA COMMENT: This article by Steven Parrish is another commentary geared towards business and high net worth individuals engaging in year-end tax planning.