TAX MITIGATION

More Tax Mitigation Strategies to Consider

Key Takeaways:

  • Maintain complete tax basis information in your records and take basis into account when making gifts (which require a carryover basis) or sales within the family.
  • Review your tax-deferred retirement plans, including IRAs and Roth IRAs, to determine their maximum investment potential and to adopt appropriate distribution strategies.
  • Be aware of rules regarding passive losses that may prevent at least the total offset of passive losses against active income.
  • A range of trusts may benefit your tax situation, including the charitable remainder trust, the charitable lead trust and the private trust known as the grantor retained annuity trust.
  • Consider the conversion of otherwise personal expenses into proper business or investment expenses that are deductible for income tax purposes.

We have already covered a number of tax mitigation strategies that may benefit you and your family to enhance your wealth. Here are some additional strategies to consider.

1. Be aware of the importance of income tax basis

With the estate tax exemption at $5 million per decedent, there will be fewer taxable estates (at least in 2011 and 2012). In any event, the 2010 TRA restored for these two years (and likely thereafter) the “stepped up” or increased income tax basis for appreciated property in a decedent’s estate to fair market value. Wealth owners should ensure that there is complete tax basis information and data in their records and take basis into account when making gifts (which require a carryover basis) or sales within the family.

2. Review and take advantage of qualified retirement plans and IRAs

All tax-deferred retirement plans should be reviewed, including IRAs and Roth IRAs, to determine maximum investment potential and to adopt appropriate distribution strategies. Consider using a Roth IRA to avoid additional income tax on investment income. That’s exactly what one financial advisor who works with CEG Worldwide did for a client recently. The self-employed client works in an industry where large swings in annual income are commonplace. After earning more than $1 million one year, he had negative income of $100,000 the next—a fact the financial advisor learned through his meetings with the client. Around this time, the client was seeking to invest in a private equity deal, which gave the financial advisor an idea: Convert some of the client’s SEP IRA to a Roth IRA, move $100,000 from the SEP to the Roth (a tax-free transfer in this case because of the investor’s negative income during the year) and invest in the private equity through the Roth. This strategy not only enabled a tax-free conversion but also ensured that the client will never owe taxes on the (ideally, very large) gains from the private equity investment.

3. Watch out for passive losses

As a consequence of the IRS focus on leveraged passive investments, certain passive loss rules now are part of the Internal Revenue Code. Essentially, these rules prevent at least the total offset of passive losses against active income, such as executive compensation. Also, there generally must be objective and subjective economic substance present—substantial nontax reasons for the venture—before any losses can be recognized.

4. Consider the use of different types of trusts

A charitable remainder trust (CRT) can receive and then sell appreciated property, spreading the taxable gain from the sale over a number of years. Also, review the possibilities of various split-interest trusts, including the charitable lead trust (CLT) and the private trust known as the grantor retained annuity trust (GRAT). Note, though, that the administration is once again proposing legislation that would be adverse to the use of GRATs.

5. Turn personal expenses into legitimate business expenses

Consider the conversion of otherwise personal expenses into proper business or investment expenses that are deductible for income tax purposes. Also, review the opportunities in any family-controlled business or investment entities for younger-generation family members to “learn on the job,” i.e., to be compensated as they develop valuable employment skills for the future.

Keep in mind that while you may be able to benefit greatly from these tax mitigation strategies, they are not enough in and of themselves to maximize your chances of achieving all that is important to you. They ultimately add up to one piece in the overall wealth management puzzle, albeit an important one. None of these five key areas of concern you face stands in isolation from the rest, which makes it important to establish an integrated approach to your overall financial picture.