If you make up part of the one percent of Americans who control over 40 percent of the United States wealth, you have a lot of choices – with taxes. The United States taxation system provides numerous loopholes that the ultra-rich happily utilize to pay the minimum amount of taxes to Uncle Sam. Taxes are one of the most important Principles of Wealth Creation.
Tax rates for payers with incomes higher than $1 million levels out at 24% and then declines for those earning greater than $1.5 million. Those that make $10 million per annum pay an average of 19% in income taxes. It is estimated that the USA loses $70-100 billion in revenue every year.
With the dreaded IRS eagerly auditing hundreds of thousands of taxpayers annually, how do the super-wealthy not get busted for not paying taxes to the United States government?
There are four main ways in which the wealthy legally “preserve” their wealth from the taxman, by:
- Giving it away: Gifts and charitable giving
- Owning multiple personal use properties: Mansions, luxury yachts (claimed as private property), etc.
- Planning generational wealth transfer via creating trusts, e.g., Dynasty trusts
- Using tax avoidance strategies: Tax havens etc
Giving it away
One can lower their taxes by giving away money (or assets) through gift-giving, and charitable contributions. These two methods enable you to avoid taxes while making you look good in the process – a real win-win!
Gift Giving
In 2019, gifts given to anyone, up to $15,000, are tax excluded. Giving expensive gifts to spouses allow the rich to enjoy unlimited tax exclusions. Gift-giving affords the wealthy the ability to circulate cash among friends and family while writing them off as gifts. Another way of distributing money within the family is by giving outright gifts of income-producing property. A Father may give stock to his adult children, a Mother can register Series EE savings bonds in the names of her children, and a grandmother may give shares (mutual funds, etc.) to her grandchildren and so on.
In general, the recipient of the gift is required to pay future income taxes on the property. For capital gain purposes, the recipient of a capital asset takes up the donors’ income tax basis, plus any gift taxes paid (donor paid), attributable to the net appreciation of the gift at the point of giving the gift.
For example, ten years ago, a Father purchased common stock at $5,000. Today, that stock is worth $20,000. He gifts the stock to his son and assuming that a gift tax did not apply, the sons’ resultant tax basis is $5,000. The son sells the stock at a later date for $30,000, making a capital gain of $25,000. The Father used the tax loophole, which allowed him to gift the stock to his son. The son, in the future, deducts the fair market value from his tax liability.
This example shows that the Father, who is in a higher tax bracket, was able to transfer potential capital gain to his son, who is in a lower tax bracket. The assumption is that the son is above 14 years of age when he sells the stock.
What is a gift tax?
Perhaps you are wondering, “What is a gift tax?”
A gift tax is an amount you may have to pay when you give a substantial amount of cash, valuable item, or, property to someone else. Depending on the type of gift and other criteria, the gift tax rate can be up to 40%. These tax rates are applicable until 2025.
When it comes to gift tax, two important rules apply: annual exclusion and lifetime exemption
Annual Exclusion
In 2019, if the gift is valued at more than the annual exclusion amount of $15,000, it will be subject to gift-tax. Gifts less than $15,000 should not be reported to the IRS, and they do not attract gift tax. Gifts above $15,000 must be reported by filing IRS Form 709. The taxable amount will be deducted until your lifetime exemption is exhausted. After that, you’ll have to pay gift taxes on gifts priced above the exclusion limit. Married couples have a combined $30,000 annual exclusion limit that can be beneficial to estate planning if properly used.
Example – A married couple has three children, all of whom are married. These parents can give away $30,000 to each person, tax-free, amounting to a total of $180,000 per annum that the IRS cannot touch. This strategy reduces the taxable value of the estate and is, therefore, a tax reduction method favored by the wealthy.
Example 2 – A single Mother gifts $50,000 to her child, with the intention of providing a mortgage down payment. The $35,000 above the annual exclusion limit of $15,000, will be calculated against the lifetime exemption, in addition to every other taxable gift purchased over her lifetime. With a lifetime exemption limit of $11.4 million, few Americans exceed this amount. It is safe to say that only rich people pay gift tax – and they avoid paying even that.
LIFETIME EXEMPTION
The estate tax systems and gift tax are connected. Estate taxes are assessed only on estates valued at $11.4 million or more for the 2019 tax year. There is a $11.4 million lifetime estate and gift-tax exemption per person, and $22.8 million per couple. When you surpass the $15,000 annual exemption limit, you are required to pay gift tax, and that reduces your lifetime exemption – the IRS keeps a total of your taxable gifts every year.
Example – if a person who has given a lifetime total of $1 million in gifts to friends and family dies in 2019, the amount of their estate that is exempted from tax is reduced from $11.4 million to $10.4 million.
- The exception to the annual exclusion and lifetime exemption amounts are:
· 1. Charitable contributions
· 2. Gifts to a spouse. In 2019, gifts given to a U.S. citizen spouse are not subject to an annual exclusion limit. Therefore, regardless of how many gifts are purchased for a USA citizen spouse, they are exempted from gift tax. Gifts given to a foreign spouse are subject to an annual exclusion limit of $155,000. Gift values exceeding the annual exclusion limit are subject to a gift tax.
· 3. Educational gifts. This applies to the payments, e.g., tuition, boarding, and lodging, etc. that are paid directly to the school, and does not cover additional expenses such as school supplies and books
· 4. Medical expenses. Applies to the amounts paid directly to the medical provider/person providing the care
Charitable Contributions
Non-profit institutions with an Internal Revenue Code section 501(c)(3) status do not pay federal income tax. However, taxpayers may donate to them and deduct the value of the contribution on their tax returns. Individual donors may deduct contributions and cash, up to 60% of adjusted gross income each year. They may carry forward any amount above the limit (excess) for a deduction on tax returns in the future, up to five years.
Calculating charitable contributions is very complicated, as specific rules apply to each donation, in light of an individual’s tax obligation. Contributions may be given in the form of financial assets, cash, or other property such as clothing, real estate, or artwork. The limits differ slightly, depending on the contribution type. With appreciated assets, donors can enjoy double benefit by deducting the full current market value while avoiding payment of capital gains tax. The donor must have owned an appreciated asset for at least one year.
One charitable donation favored by the super-wealthy is creating conservation easements.
Example – A large plot of land can be designated as conservation land, green space, in an overly developed area. Most land conservation trusts work with the owners of green properties, e.g., parks, allowing them to take charitable deductions for the conservation easement value that they put into the park.
Average taxpayers can also take a deduction. To do so, they’d have to itemize their taxes. The Tax Cuts and Jobs Act standard deduction, in 2019, currently stands at $24,000 for married couples and $12,000 for individuals. Itemized deductions would have to be more than the above-mentioned amounts.
Owning Multiple Properties
Owning additional residences does not necessarily offer substantial tax benefits. However, when talking thousands of dollars in taxes, every tax reduction strategy works. On federal income returns, taxpayers can save on property taxes by deducting state and local property taxes on two personal homes. Guess what; some yachts are considered private homes!
This particular property tax deduction is limited to two residences: a principal residence and an additional residence. IRS rules specify what constitutes a personal residence. Up to $750,000 in mortgage interest is also deductible.
Rental properties also enjoy additional tax benefits. To qualify as a rental property, the home must be leased out for over 14 days a year, or 10% of total rented days, whichever is greater. An owner who spends 30 days each year at a residence, must rent it for a minimum of 300 days to qualify for the deductions.
The expenses of conducting business will also be deductible, e.g., travel to show the property, property advertising, etc. Cleaning, maintenance, professional fees, insurance, common charges, and utilities are also deductible.
Owners operating multiple homes as business ventures are eligible for a 20 percent qualified business income deduction. According to the IRS, the company must be run as either a sole proprietorship or limited liability company, S corporation, partnership, estate, or trust.
Therefore, real estate investors with LLC businesses do not pay income taxes. They pass the tax forward to the owner/owners of the company:
• Individual owners who earn less than $157,500 get taxed on 80 percent of their income from that business
Couple owners who earn less than $315,000 get taxed on 80 percent of their income from that business
Those with higher income, $207,500 for individuals, and $415,000 for couples have a more complicated deduction methodology. The calculation is dependent on the qualified business income, W-2 wages paid, and the unadjusted basis of qualified property. Regardless, owners are taxed at individual rates and not corporate rates.
Planning Generational Wealth Transfer: Dynasty Trusts
A dynasty trust is created to transfer wealth from one generation to another without incurring transfer taxes, for example, generation-skipping transfer tax (GSTT), gift tax, and estate tax – as long as the assets remain in the trust. The main characteristic of a dynasty trust is its long-term duration. A well-designed trust, established in the right state, can last for multiple generations, even forever.
Historically, many states had rules against perpetuities. Therefore, they stipulated the duration of a trust, from start to end. A trust could run, at most, for 100 years. However, some states have done away with these rules, enabling dynasty trusts to last forever.
In a dynasty trust, which is a type of irrevocable trust, the immediate beneficiaries are the children of the grantor. When all the children die, the grantors’ grandchildren and or great-grandchildren become beneficiaries. The trust is usually controlled by a trustee which is typically a financial institution appointed by the grantor. Putting assets in a dynasty trust and similar irrevocable trusts is sometimes also referred to as “trust freezing.”
Example – A grantor leaves $10 million to their beneficiary. If the inheritance grows, over 25 years, to $25 million, at the beneficiary’s death, it would be subject to estate tax. In 2019, with federal estate taxes rates pegged at a top rate of 40% and with a $11.4 million exemption, more than $5.4 million dollars would go towards paying the estate tax ($25,000,000 – $11,400,000= $13,600,000 x 40/100= $5,400,000).
That massive amount would not be owed in taxes if the money had been put in a well-drafted dynasty trust, where it would have appreciated via investing.
Key takeaways of dynasty trusts are
- • They enable wealthy individuals to bequeath sums of money and assets to future generations, which do not incur any estate taxes during the transfer process. In 2019, up to $11.4 million can be transferred to a dynasty trust without incurring either gift, estate, or GSTT taxes
- • They protect assets from creditors and ensure that your children and their descendants have an inheritance. A dynasty trust also safeguards the assets from the beneficiary’s creditors
- The terms of dynasty trusts cannot be changed once funded because they are irrevocable trusts. Irrevocable trusts usually have grantors who set strict (or lax) rules as to how the trustees should manage and distribute the assets to beneficiaries. Once transferred, the grantor will not be permitted to amend the terms or have control over the assets. This loss of control ensures that the grantors and beneficiaries separate taxable estates receive an amount of tax relief
Tax Avoidance
Tax avoidance differs from tax evasion in that tax avoidance is legal, while tax evasion is not. This section mentions a few tax avoidance methods that are legally utilized by wealthy people, to enjoy a measure of relief from their tax burden. There are other methods used by the ultra-rich, which are way too complex and super expensive to implement – so this list is far from conclusive.
tAX hAVENS
Offshore tax havens, such as the British Virgin Islands, the Cayman Islands, etc. are used by the 1% to hide their wealth safely. These tax havens offer either zero taxes or negligible amounts in taxes. Individuals register their companies and or open banks accounts with financial institutions located in these tax-free zones
Compensation In Stock Options
Stock options are taxed only when exercised. High net worth individuals also do not mind getting paid in stocks because they can tolerate risk. So, numerous executives opt to receive their compensation in stock options. This allows them to control when and if they pay taxes. When it is time to sell, taxes on stocks are typically lower than the tax rates on wage income, assuming stock ownership of more than a year.
Depending on income, long term capital gains taxes are 0%, 15%, and 20%. In comparison, federal wages tax rates are 10% for the lowest earner to 37% for the highest earner. They can also give the stock as gifts and or use various methods to avoid paying taxes. Alternatively, they can hold out for favorable tax changes, which allow them to pay lower taxes.
sHELL companies
This is a particularly shady method. The ultra-rich open shell companies which exist only on paper and do not provide any products or services. These companies are legally formed and are often used to avoid reporting international business operations so as to avoid paying taxes.
Do not use this method if you plan to run for office. It is particularly frowned upon by the electorate
Equity Swap
Instead of selling an asset and transferring ownership, which incurs taxation, two parties enter into an agreement that allows them to exchange the assets gain and loss. This swap arrangement avoids transaction costs and local taxes on dividends
Dodgeball
A popular loophole pertaining to the capital gains tax involves purchasing stock options. On buying the stock options, the holder borrows money from an investment bank by using the shares as collateral. Thereafter, the borrower repays the loan with the money made with the borrowed money. Alternatively, to avoid paying the capital gains tax, the loan can be repaid by handing over the shares
Incorporate personal brand
Being a corporation has added tax advantages compared to being in a higher tax bracket. Under certain circumstances, for example, a limited liability company (LLC) is created to manage multiple investments, such as real estate, portfolio assets, or a business.
So, wealthy individuals opt to incorporate their personal brands, which act as management companies. These corporate structures manage their assets and provide them with advice and oversight, allowing them to:
• Channel wages through a corporation
• Pay themselves interest-free wages
• Claim expenses
• Significantly reduce their income taxes
Please be advised; this fee conversion practice is illegal in some states because it takes advantage of lower capital gains taxes, which should be provided only to those that take financial risks in business environments.
Deferred Compensation
One may also put a portion of their payday in a deferred-compensation plan. Compared to taking one’s salary all at once, this payment method allows one’s earnings to grow, tax-deferred, for over ten years. A DCP is normally designed to supplement an employee’s retirement income and can be arranged on a pre-tax or after-tax basis.
If on a pre-tax basis, the distributions will be larger than on an after-tax basis, due to their ability to grow without incurring taxes (tax-deferred) for the next 20-30 years. In addition to a larger future payout, there are added benefits, which include payroll tax savings and Medicare tax savings.
Example – A 45-year-old employee may defer $25,000 of pre-tax income into a DCP that will grow its cash value in conjunction with a life insurance policy. It will grow until the employee’s 65th birthday. At that point, the DCP contributions will amount to $500,000.
At age 70, the employee will be able to withdraw an annual income of $139,000 tax-free income for 15 years, that is, until age 85. The employee will also have a life insurance cover for approximately $1 million.
Tax-Planning Caveats
Tax planning can produce savings and is part and parcel of good financial planning. However, it should not be overemphasized. In your desire to save taxes, avoid sham transactions that have no economic substance and which will instead expose you to dire tax consequences.
Only pursue legitimate ways of reducing your tax burden. Saving on taxes should also take into consideration your other financial decisions in their entirety.
Always have in mind the trade-off – what are you giving up so that you can save on a few taxes? Are you giving up critical control, flexibility, or any other advantage? Are you perhaps unwittingly incurring unnecessary costs and extra tax payments – or telling lies that will catch up with you and subject you to an IRS audit? Make sure that the tax-saving that you seek justifies the means and does not expose you to an IRS investigation!
Finally, always engage a certified public accountant, an Internal Revenue Service expert, who will carefully examine your cumulative income, and advice you on your tax options. Tax laws are updated every year; your financial circumstances could also change, necessitating an adjustment in your tax reporting.
Sources
Hallman, G. V., & Rosenbloom, J. S. (2003). Personal Financial Planning Seventh Edition. Chicago, IL: American Psychological Association.
https://www.topaccountingdegrees.org/taxes/
https://www.investopedia.com/terms/d/dynasty-trust.asp
https://www.taxpolicycenter.org/briefing-book/what-tax-treatment-charitable-contributions
https://www.mansionglobal.com/articles/can-you-get-an-income-tax-break-if-you-own-multiple-homes-in-the-u-s-108951
https://www.investopedia.com/terms/d/dynasty-trust.asp
https://www.cnbc.com/2019/02/21/here-are-5-ways-the-super-rich-manage-to-pay-lower-taxes.html
https://www.fool.com/knowledge-center/what-is-the-gift-tax.aspx
https://www.edelmanfinancialengines.com/education-center/articles/10-tips-to-help-ensure-your-charitable-donations-will-be-tax-deductible
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https://www.nolo.com/legal-encyclopedia/dynasty-trusts-tying-up-the-family-fortune-forever.html
https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/
https://www.nerdwallet.com/blog/taxes/federal-income-tax-brackets/
https://www.accountingtoday.com/opinion/multiple-uses-of-a-deferred-compensation-plan-in-the-workplace
https://www.wsj.com/articles/wsj-tax-guide-2019-charitable-donation-deduction-11550235600
https://www.wsj.com/articles/wsj-tax-guide-2019-charitable-donation-deduction-11550235600
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