Tax Planning

By Chris J. Roe, CPA, PFS

As many high-net-worth professionals are aware, the US Government taxes long-term capital gains (gains on capital assets held for over a year) at a lower income tax rate (0-20%) compared to other income sources such as wages, business income, or interest. However, the complexities of capital gains taxation and their interplay with ordinary income are often misunderstood.

The Impact of Capital Gains on Ordinary Income

Recognizing capital gains in any tax year may result in a higher overall income tax on ordinary income. In other words, your wages, IRA distributions, Social Security, or interest income could be subject to a higher tax rate if you have capital gains. When considering the sale of a business, real estate holdings, or realizing stock incentives, it is crucial to plan ahead and account for the effect that capital gains will have on your income taxes.

The interaction of capital gains with ordinary income in determining your tax rate can be intricate and requires proactive management. Fortunately, numerous planning opportunities are available, but preparation and foresight are essential to maximizing their effectiveness. Realized capital gains increase your adjusted gross income (AGI), which may affect your ability to make Roth IRA or tax-deductible contributions, reduce available tax credits, and increase the hurdle for claiming medical expenses, among other consequences.

While capital gains influence certain tax benefits, long-term gains are taxed at a lower rate than ordinary income and do not push you into a higher marginal tax bracket. However, it is essential to remember that short-term gains are taxed at ordinary rates. Realized long-term capital gains do not force your ordinary income into a higher marginal tax bracket. Still, they may result in higher taxes due to reductions in available tax deductions and tax credits.

However, if you know how to navigate the numerous capital gains deferral or elimination opportunities, you can save a lot of dough. 

Planning Opportunities for Capital Gains

Paying a 0% or 15% Capital Gains Rate

In 2018, the tax code was updated to introduce a 0% tax rate on long-term capital gains for taxpayers in the 12-22% tax bracket. In our experience advising clients, individuals who typically fall within this bracket are either less wealthy parents or adult children beginning their careers. It is important to note that dependent children are generally excluded from this provision, as they are typically required to pay taxes at their parents’ rate.

When planning for a significant capital gain event, it could be strategically advantageous to gift an interest in the asset to your parents or adult children, as this may result in an overall lower capital gains tax liability. 

Stepping Up Your Income Tax Basis Before a Sale

If you anticipate a substantial capital gain event and have aging parents or grandparents who may pass away before the event occurs, it is possible to strategically achieve a step-up in basis on the asset. One approach is establishing a trust for your spouse, children, and aging family members.

By setting up the trust and granting your aging relatives a general power of appointment within the trust to allocate assets to the creditors of their estate, you cause the assets to be included in the elder’s taxable estate. As a result, these assets qualify for a fair market value step-up on basis upon their passing.

Consider this example: Sammy Business Owner establishes a trust for his wife, children, and 98-year-old grandmother and gives $5 million worth of company stock with a $100,000 basis to the trust. The trust provides Sammy’s grandmother with a general power of appointment to allocate assets upon her death to the creditors of her estate. Upon her passing, the company stock’s basis increases to $5 million, up from $100,000. This strategic move saves Sammy and his family a cool $1.1 million in taxes.

Moreover, Sammy retains access to the funds in the trust, as his wife is a beneficiary. 

Deferring the Capital Gains through an Installment Sale

It’s still possible to sell your stock or other assets to a trust for your family’s benefit and receive a promissory note in return. The note may require principal and interest payments over an extended period, such as 10, 20, or 30 years. With each installment payment you receive, you’ll recognize a partial capital gain.

Selling the asset is considered a taxable transaction, so the trust purchasing the asset receives a stepped-up basis. Consequently, when the trust sells the asset, it generally experiences little to no gain. As you might imagine, the IRS wasn’t fond of this transaction and attempted to eliminate it. However, they only partially succeeded.

These transactions remain viable, but they do require advanced planning. If an installment sale occurs between related parties and the related party sells the asset it purchased within two years, the transaction is unwound and deemed to have occurred on the date of the initial installment sale.

As you can see, to make this strategy viable, you must plan more than two years in advance. In our experience, the more time you have to plan, the better the outcome.

Using a Like-Kind Exchange

If you’re selling investment real estate, you can exchange it for like-kind property of generally greater value and defer the gain. Keep in mind, however, that the exchanged property must be like-kind and held for investment purposes, not a personal residence such as a beach house or ski lodge.

For example, Johnny Real Estate owns an apartment building he built 30 years ago with a $0 basis. He wants to sell it because he has an opportunity to purchase another apartment building he believes will appreciate faster. By performing an exchange, Johnny can defer the capital gains tax. This transaction is subject to a complex set of rules and requirements, so it’s essential to consult with professionals before proceeding.

It’s worth mentioning that the Biden Administration has proposed eliminating the like-kind exchange from the tax code in their recent budget proposal.

Using Charitable Trusts to Create Installment Sale Treatment

Similar to deferring gains through an installment sale, you can establish a charitable trust that makes lifetime payments to you and your spouse.

When you give appreciated assets to the trust, you’ll be entitled to an income tax deduction for the portion considered a charitable contribution. Then, on an annual basis, you’ll receive income from the trust, a portion of which will be taxed as a capital gain.

The downside of this strategy is that if you and your spouse pass away early, any remaining assets in the trust will go to a charity of your choice instead of your heirs. To address this concern, consider supplementing the trust with 10-20 year term life insurance. In the event of an early death, your family will receive life insurance proceeds to replace the assets given to charity, ensuring their financial well-being.

Opportunity Zone Investing

In 2018, Congress passed legislation enabling the investment of capital gains into Opportunity Zones (i.e., real estate). By investing your capital gains in these zones, you can defer gain recognition until 2026. Moreover, if you hold the asset or fund for 10 years, your gains from the fund are taxed at 0%.

Opportunity Zones offer a straightforward method for capital gain deferral, but we advise against allocating a large portion of a family’s wealth to these investments solely for deferral purposes. Your money will be locked up, concentrated in real estate, and exposed to operator risk.

Active Tax Loss Harvesting

Actively harvesting tax losses in your liquid investment portfolio can help offset gains realized from a significant sale. Your investment advisor should proactively build up a tax loss reserve in preparation for when large gains are recognized.

Furthermore, when a sizable sale occurs and funds invested, short-term losses may arise. These losses can also be harvested, provided they occur within the same tax year.

Using Tax-Deferred Accounts for Gains

If you plan to invest in certain assets expected to appreciate rapidly, consider doing so within your Traditional or Roth IRA. For instance, if you’re investing in a startup company that you expect to soar, you can purchase their common shares within your IRA.

A Forbes article recently highlighted how Peter Thiel, PayPal co-founder, grew his Roth IRA to $5 billion using this technique to invest in startups.

However, be cautious, as these transactions have many rules, and the last thing you want is for the IRS to say you entered into a prohibited transaction, disqualifying your IRA. This can be a significant tax trap for the unwary.

It’s worth noting that the Biden Administration has proposed mandatory large distributions for what they consider “Large IRAs.”

Plan Ahead and Consult with Professionals

Whether you plan to sell this year or are contemplating the sale of a substantial asset in the future, it’s crucial to consult with professionals and develop a strategic plan as far in advance as possible.

If you’re interested in a free initial consultation and considering selling a business or large asset, please don’t hesitate to reach out and schedule a time.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

By Chris J. Roe, CPA, PFS

One of the biggest concerns we hear from our high-net-worth clients is how they can lower their tax burden. Those concerns are only growing with the release of the Biden Administration’s tax proposals that look to raise income taxes on high-earning business owners, professionals, and the wealthy.

Their proposal includes:

1. Increasing ordinary income tax rates at the highest level from 37% to 39.6%, 
2. Increasing dividend and capital gains rates to the top rate of 39.6% for taxpayers making over $1 million,
3. Charging the 3.8% net investment income surcharge on S-Corp distributions, 
4. Eliminating valuation discounts on the transfers of interest where the family owns at least a 25% stake in the business,
5. Treating the grantor’s payment of income tax on a trust as a gift,
6. Treating transfer of appreciated property by gift or death as a taxable event,
7. Limiting the benefits of certain estate planning techniques, such as grantor-retained annuity trusts and taxing sales to grantor trusts, or
8. Limiting an exclusion of certain gifts to a total of $50,000 per year, not the $17,000 per donee exclusion. 

If you take action now, it is possible to sidestep the above proposals should they become law. So, what are we thinking about and advising our wealthy clients to do? Here are a few suggestions:

• Use your annual exclusion gift amounts to transfer appreciated investments to children. If your child is independent and in a lower tax bracket, it may make sense to transfer appreciated investments you are going to sell to your child and allow them to sell and recognize the gain. 
• Give your less wealthy parent assets. This is the same as giving to your child. Additionally, if your less wealthy parents do not sell the investment but pass away, you will get a step up in basis and avoid the tax. Your parents can even leave the money to their grandchildren or great-grandchildren, preserving your lifetime exemption.
• Donate appreciated stock to a charity. Always use appreciated investments to give to charity. You get a tax deduction for the fair value of the donation and avoid tax on the appreciation. Make sure you’ve held the investment for greater than one year. Also, lump your gifts into a single year using a donor-advised fund to ensure you maximize your itemized deductions.
• Set up a charitable trust. If selling appreciated assets, consider setting up a charitable trust to defer the gain over many years while still getting an income stream.

• Set up a Roth IRA for your child. If your minor child has earned income, you can contribute to a Roth IRA on their behalf – growing tax-free during the child’s lifetime. 
• Create a trust for your spouse and make gifts and sales of assets. Your spouse may serve as trustee and make distributions to themselves and your children. Also, it is a grantor trust, so you can pay the income tax and make sales before any proposals of taxation pass.

• Set up a trust for your children. There is a way to establish a trust for your independent children that will tax them on the income the trust earns, not you. Consider gifting some of your business interests to the trust so the children can pay the tax at a lower rate than you – enhancing the overall family wealth.
• Consider using life insurance and annuities to shelter taxable income. Should the capital gains rates change on high-income earnings, you may consider using certain life insurance contracts and annuities to shelter investment earnings from current tax. It may be possible to kick the can down the road to a lower tax environment. Be cautious—the contracts need to be specifically designed and not just bought from any insurance agent touting the tax benefits of a contract.
• Utilize Roth IRAs. When high tax environments exist, Roth IRAs become important to have and grow for potential future use when you need funds but do not want to pay tax to access them.
• Utilize tax-deferred retirement plans. Look at your retirement plan’s design. When you are in the highest bracket, it makes sense to maximize tax-deductible contributions.
• Utilize 529 plans. While these are primarily meant to fund college, you may use them for other purposes if you are wealthy. These are generally protected assets from creditors, and investment earnings are not taxable annually. If you hold the funds long enough to get significant tax deferral and allow your children to possibly use them as a retirement vehicle, the overall tax deferral will more than makeup for the extra 10% tax, if a withdrawal is taken. By the way, it is possible your grandchildren or great-grandchildren can use them for education or their lifestyle spending. Think about the earnings compounding over, say, a 50-100 year period.
• Make a sale of assets to a grantor trust. Before any proposal becomes law, make a sale of assets to a grantor trust to provide the flexibility of forgiving the note or just taking back the asset to settle the note should the laws change. It gives flexibility. This should be done with care and proper counsel.
• Establish a grantor trust. While you may not want to transfer assets in trust currently, you may want to set up a trust now to give you flexibility in the future. The Administration’s proposal calls for the taxation of sales to the trust and taxes paid on behalf of the trust to be treated as a gift for trusts created after the new law is passed, not before. 
• Limit the duration of the GST Exemption. Many wealthy families use what is referred to as a Dynasty Trust. It is a trust meant to be exempt from estate tax for many generations. The proposal wants to limit the time of the exemption. So to ensure you beat any law change, set up a dynasty now in a state that allows the trust to go on for a long time. Fund with a few small assets and allow it to be grandfathered under any law change. This will give flexibility if you want to gift assets to your children and grandchildren in the future.
• Use second-to-die life insurance to create a legacy. Should the step-up in basis be repealed, leveraging tax-free life insurance on you and your spouse to benefit children and grandchildren becomes much more attractive. When evaluating if a client should do this, we always analyze it from a return to life expectancy. Remember, life insurance is an asset that needs to be reviewed and managed. If it does not provide an attractive return. However, if structured properly, we believe every wealthy family should have some life insurance as part of the family’s diversified assets. This also leverages wealth that can pass in a dynasty trust should the law change.
• Using life insurance to achieve a step-up in basis. Life insurance is tax-free when received, and its earnings inside of a policy grow tax-deferred during its lifetime. Consider using it inside of a dynasty trustto grow assets for your grandchildren. When you die, they receive the benefits tax-free effectively, giving them a step-up in basis even if the law eliminates step-ups.
• Basis step-up using parents or grandparents. If your grandparents or parents are older and have no estate tax issues, consider setting up a trust for your spouse, children, and parents/grandparents. When your grandparents or parents pass, there is a way to make the trust includable in their estate and to achieve a step-up in basis, thus, avoiding income tax on all appreciation of the assets in the trust. This may change if no step-up becomes law but may be grandfathered if done before any law change.

As always, you should seek professional counsel before implementing any strategy, which should work within the context of your family’s overall financial plan. While saving taxes is important, it is not the end goal – it is part of a thoughtful, coordinated plan to manage and grow a family’s wealth over time. Should you need advice on your personal situation or want to discuss a strategy you believe will work for you, please feel free to reach out for a free consultation.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

While we are providing this as general advice, you should always consult your financial advisor,  tax advisor, or attorney before implementing any of these strategies.

By Chris J. Roe, CPA, PFS

Creating a new business is exciting. Yet, knowing which legal business entity to operate under can be difficult since there are several options, each with its benefits and concerns. [1]

When choosing a business entity, you must consider the legal aspects, such as asset protection, who owns the entity, and how it will be taxed. Moreover, consideration needs to be given to the amount of annual administration needed to maintain the business entity. For example, corporations need to hold annual meetings and maintain minutes, or else there is a possibility that if sued, the liability protection afforded by the corporate structure may be lost. 

It is extremely important in operating a business entity to respect the formalities. Many business owners operate the business like their personal piggy bank, which could bring about unwanted legal and tax issues.

There is always a need to save money during the initial setup of starting a business, but you shouldn’t skimp on forming the business entity. You should always consult a qualified attorney and a CPA before making any decisions on the business structure. Do your research and understand the pros and cons of each business entity and how it protects your personal assets. 

While not a replacement for professional advice, this overview of the common business entities can help you choose the right one for your situation.

Sole Proprietorship

Sole proprietorships are businesses owned by just one person and easily established. A sole proprietorship provides no personal asset protection to the business owner. 

Forming and maintaining a sole proprietorship is easy, and no separate income tax return is needed. The business income must be reported on the Schedule C of the owner’s income tax return. [2]

With no protection between personal and business assets, owners become personally liable for their business’s financial obligations. However, it is recommended the business owner maintain a separate checking account for the business and keep appropriate accounting records.

This entity is generally best suited for businesses such as consulting, retail, freelance work, or other services provided directly by the owner and with no employees other than the owner. Since the owner is the sole employee and provides all services, other business entities may offer little asset protection.

Partnership

These are business entities owned by at least two people. Partnerships are not taxed at the partnership level but pass through their taxable income and losses to each partner based on their ownership percentage. The partners report the income or loss on their personal income tax return. [3]

If you are a general partner in a partnership, you will have exposure to the partnership’s liabilities. However, if you serve as a limited partner, your liability is generally limited to the money invested.

As for business control, general partners usually run the business. The operations are defined by a partnership agreement. As a limited partner, you have by definition, a “limited” say in the business operations. 

Additionally, partnerships cost more to form than sole proprietorships due to the fact an attorney will need to draft the partnership agreement.

Finally, smaller groups of similar or complementary professionals, such as medical professionals, lawyers, and CPAs, generally operate as a partnership since they are looking to market their services under a single name and share business operations and control. 

Limited Liability Company (LLC)

An LLC is treated as a separate legal entity that is distinct from its owners. It provides a layer of asset protection for the owner’s personal assets. However, an LLC provides great flexibility on how it is taxed. Depending on the number of owners, it may be taxed as a sole proprietor, partnership, corporation, or S-Corporation. LLCs can provide great flexibility. [4]

There is a default tax treatment for an LLC based on the number of owners and whether it is foreign or domestic. However, owners may elect to be treated differently for tax purposes under certain circumstances. [4]

Also, certain states, such as Wyoming, Nevada, and Delaware, provide better laws for forming and operating an LLC. However, when forming an out-of-state LLC, there are additional costs. 

Businesses and their owners looking for the protection and separation of personal assets from the business while gaining ultimate flexibility with the corporate formalities may consider forming an LLC.

C-Corporation

A C-Corporation, also commonly known as a C-Corp, operates as its own distinct entity and offers personal liability protection to its shareholders. However, C-Corps also require more annual administration, such as meetings and recording of meeting minutes. Moreover, the corporation files its own income tax return and pays its own taxes on profits. Additionally, it may pay a higher corporate income tax rate than an individual shareholder might pay if the income were taxed on their personal tax return. 

Full personal protection, the ability to generate funds through the sale of stocks, and potential tax advantages give C-Corps the support to operate for years to come. Additionally, the Federal tax code provides for gain exclusion in certain circumstances on the sale of corporate stock. [5]

The inherent disadvantage to operating a C-Corp is double taxation. C-Corps are taxed on their profits, and shareholders are taxed when they receive their dividends. This can result in a Federal tax as high as 39.8%.

With the introduction of the Qualified Business Income Deduction on pass-through entities, operating as a C-Corp may just be too costly. [6]

On the other hand, for businesses that will earn little money in the start-up phase but provide a large gain on a future sale, C-Corps may be a good operating structure.

S-Corporation

S-Corporations, also commonly known as an S-Corp, provide the same personal liability protection as a C-Corp while eliminating double taxation. However, S-Corps have their own restrictions on who can be a shareholder. [7]

S-Corps cannot tap into some of the tax advantages of a C-Corp and are required to have no more than 100 shareholders, all of whom must be U.S. citizens. [1] 

Businesses and owners may gain advantages from the C-Corp structure while avoiding double taxation. Additionally, business owners who meet certain requirements may qualify for the Qualified Business Income Deduction, thus lowering the effective Federal income tax rate on taxable income. [6]

Consult a Tax or Legal Professional

Keep this information in mind as you go through the process of establishing your business entity, but remember that this is only a general overview and should not replace professional, personalized advice and recommendations you may receive when collaborating with a lawyer or CPA. Make sure to consult an expert and do not be penny wise, pound foolish when starting a new venture. 

If you are considering starting a new business and need a complimentary consultation, please reach out to Rx Wealth.

Sources: 

1. https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
2. https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships
3. https://www.irs.gov/businesses/partnerships
4. https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
5. https://www.law.cornell.edu/uscode/text/26/1202
6. https://www.law.cornell.edu/uscode/text/26/199A
7. https://www.law.cornell.edu/uscode/text/26/1361

 

This content is developed from sources believed to be providing accurate information, and provided by Rx Wealth Advisors, in conjunction with Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

By Chris J. Roe, CPA, PFS

Ideally, tax planning should be a continuous process undertaken all year long, possibly over multiple years, to achieve the greatest gain. However, it tends to be more top of mind at the end of the year when the time to take action to lower the current year’s tax burden is running out. Here is a list of a few tax planning strategies you may want to take advantage of as we approach the end of 2022. 

• Shift ownership of business entities to lower-income taxpayers or entities. This may also help you take advantage of the Section 199A deduction, which allows qualified trades or businesses to deduct 20% of qualified business income, subject to certain limitations.
• Consider “bunching” charitable donations through a donor-advised fund (DAF), especially if you are in a high tax bracket this year and expect to be in a lower one in the future.
• Another reason to consider bunching donations: The $300 above-the-line charitable contribution deduction was not extended past 2021, so the only way to deduct your charitable contributions this year is to itemize rather than take the standard deduction. Bunching donations for multiple years into a single year will help you accumulate enough deductions to make that possible.
• If you have children in a lower tax bracket, hiring them to work for you in the business can be advantageous. You’ll receive a nice tax deduction for the salary you pay them, and they will pay little to no taxes on the income (depending, of course, on their tax bracket). For example, in 2022, your child will be exempt from Federal income tax for the first $12,950 of earnings. (Physicians, read my full article on the benefits of hiring your child here: Should I Hire My Child in My Physician Practice?)
• If you are considering selling your business before year-end or next year, consider setting up a defective beneficiary trust for your child in a lower tax bracket and gifting an ownership interest. This may allow for capital gains to be taxed in a lower bracket.
• If you are selling your business and you’re charitably inclined, consider contributing the shares of the business to a donor-advised fund or using a charitable remainder trust to defer gain. Note that if you are taxed as an S Corp, gifts to donor-advised funds come with special rules, and a charitable remainder trust is not an eligible shareholder.
• If your 2022 income is low, consider triggering tax on your accounts receivable to accelerate income into the low tax bracket year.  Also, consider deferring your accounts payable until next year when you are in a higher tax bracket.
• If your business is generating a net operating loss this year, consider a Roth IRA conversion. The income created by the Roth can be offset by the net operating loss, and there’s no limit on the amount of income that can be offset. This can reduce or eliminate the income tax liability on the Roth.
• So long as you have no Traditional IRAs at the end of 2022, you can make a backdoor Roth IRA contribution.
• Make sure you are on track to maximize your 401(k) employee contributions of $20,500 if you are under 50 and an additional $6,500 if you are 50 or older for a total of $27,000.
• Evaluate your business retirement plan and see if it is designed to allow the owner(s) to maximize profit-sharing contributions. 
• Consider if a cash balance plan is right for you and your business. This type of retirement plan allows for large tax deductions.
• If you are in a lower tax bracket than you expect to be in the future, you may want to consider contributing to a Roth 401(k) rather than a tax-deductible retirement plan such as a traditional 401(k). This way, you pay taxes on your contributions now at your lower tax rate.
• Consider converting a vacation home to a rental property. If the property is rented, and you later sell the home at a loss, you will get to claim a capital loss. Otherwise, the property is considered personal use, and capital losses are not allowed. 
• Depending on your current tax structure, it may be beneficial to set up a complex trust to make charitable contributions from in the future. While individuals can only take a charitable contribution deduction of 50% of their adjusted gross income (AGI), complex trusts can deduct up to 100% of their net income.
• If you own mutual funds, check to see if you’ll be receiving any distributions this year, and if so, determine if it is more cost-effective to sell the mutual fund before the distribution.
• Evaluate the tax efficiency of your taxable portfolio. For greater tax efficiency, consider reinvesting any distributions or new cash using exchange-traded funds instead of mutual funds.
• If you are over 70 ½ and have not yet taken your required minimum distribution from your IRA for 2022, consider donating part of it to charity as a QCD – Qualified Charitable Donation. This allows you to reduce your AGI without having to itemize your deductions. 

These are just a few opportunities to save tax dollars. Should you need advice on your personal situation or want to discuss a strategy you believe will work for you, please feel free to reach out for a free consultation.

While we are providing this as general advice, you should always consult your tax advisor or attorney before implementing any of these strategies.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.