The issue of taxation for the wealthy is a source of constant debate in the media and in the political spectrum.
The issue of taxation for the wealthy is a source of constant debate in the media and in the political spectrum. Regardless of your stance on tax breaks, there is no doubt that the IRS is cracking down on the traditional “tax havens” typically reserved for the wealthy — particularly abuse of charitable contributions, offshore bank accounts and trust formation. In fact, those three techniques are listed on the IRS’s annual Dirty Dozen list.
Additionally, most wealthy Americans are not eligible for the most common tax breaks, such as deductions on retirement contributions, being allowed to participate in a Roth IRA, the Earned Income Credit or certain education and child tax credits.
Here are some suggestions of legitimate methods for tax breaks for the wealthy. Of course, consult with your financial adviser or accounting professional before proceeding.
Own your own business
Odds are that if you’re wealthy, you are a business owner — and potentially the only owner of the business, even if it only supplements your W-2 income.
With that said, if you already own a business, you are likely versed on many of the tax benefits this method provides. However, since this is the simplest tax-saving vehicle, it may make sense to take stock of your stock and make sure you are getting the most out of it from a tax-savings standpoint. Apart from the ability to write off ordinary business expenses, the incentives can go a great deal deeper.
Even if you already own a business, consider starting another one. To take advantage of the tax benefits, you only have to show a profit-motive and not actually make any money. One court case pitted the IRS against a business that lost money for 20 straight years — the business owner won, and such decisions are common.
Operating a money-losing business might not make sense to some, but if it is a result of legitimate business deductions, you may also be able to claim passive losses to help reduce your total income tax burden. For instance, if your business reports a loss of $1,000, you can take that $1,000 as a passive loss on your income tax return and subsequently reduce your adjusted gross income. The key is to show the IRS that you are trying to make money. The litmus test is relatively subjective, but if you are running the business with aspirations of making a profit, then you should be in the clear. Also consider the IRS Form 5213; it precludes any IRS challenge regarding the profit motive of your business for the first five years. This is important considering the IRS looks for you to make money in three of the first five years to qualify as a profit motive, so losing money for five years may arouse some suspicion.
For more established businesses that are turning a profit and in which you, as the owner, are showing earnings, consider things such as hiring your children and funding a SEP-IRA.
Make a second home of your yacht and you’ll find a big tax break.
For instance, hire your kid to help with paperwork or some tech support, pay a reasonable wage and claim the expense as a deduction — all the while keeping the money in the family. Even better, rather than paying your child directly, set up an IRA for your child and send the wages to it. Keep in mind that the child’s wages need to stay under $5,350.
However, the SEP-IRA works best, which could further supplement the above technique. In an SEP-IRA, the employer (your business) can contribute up to 25% of your wages into your IRA. For instance, if you made $40,000 last year from your business, your business can fund $10,000 into the SEP-IRA, which removes the profit from the corporate books and puts them into your retirement account. There are limits imposed on this: up to $44,000 for 2006 or 18.6% of the business’ net profit.
However, if your business makes plenty of money, defer the tax liability now, reduce the profit of your business today, and you can aggressively fund your retirement (compared to the $4,000 to $5,000 limits allowed by Traditional/Roth IRAs). There are some complexities to this approach; you must extend the same treatment to all employees. Consult your tax professional for the fine print.
International real estate
Owning vacation homes in the Smoky Mountains or on the Aspen slopes are luxuries that the wealthy can afford and often have. However, if you have a taste for world travel and are looking for a vacation-home setting that offers superior tax incentives, consider investing in a foreign country. Specifically, Central America’s Panama makes an excellent venue to consider.
Apart from the obvious things, such as lower property prices, the government has actually developed a very specific program to encourage foreign investment within its borders. Programs vary by country in Central America, but are becoming increasingly common, especially in countries that have fairly stable governments and encourage tourism as one of their top industries.
In September 2006, Panama announced new rules that gave tax exemptions of up to 15 years on construction of new homes. Specifically, a residential home with value up to $100,000 gets a 15-year tax exemption on property taxes; $100,000 to $250,000 homes get a free pass for 10 years; $250,000 and up get five years. More importantly, these incentives are transferable when the property is sold and there are similar exemptions for commercial buildings and developments.
If you are looking to retire or to make Panama your primary residence, interest rates are available at up to 6.5% less than regular rates. Additionally, in specially marked tourism special-interest zones, you will find even more aggressive incentives: There’s a 20-year exemption on real estate tax and, should you want to start an enterprise, expect a 15-year exemption on income tax derived from tourism activities and a 20-year import-duties exemption on many items required to run your operation. Old Panama City offers additional incentives as well, such as 10-year income-tax exemption and a 30-year property tax exemption from the sale or rental of property.
Your second home - a boat?
Cars and houses can be used for tax deductions. You can write off business miles on your car, of course, and the interest paid on your mortgage is tax deductible. Yachts enjoy similar tax treatment in many ways, but it seems to be a gray area with the IRS, leaving it open to all sorts of interpretation. Semi-retired CPA Jimmy James believes that most people with 50-foot yachts are looking for tax breaks. He remarks, “people with enough money to buy those boats got there by having tax dodges."
A very powerful, but soon expiring tax break is the accelerated depreciation on a boat, which becomes particularly helpful for multi-million dollar mega-yachts. It is possible to quickly depreciate the yacht, which could have a significant impact on your tax bill and can easily translate into a five-, six- or even seven-figure deduction on your taxes. Bury the hatchet and become a Family Limited Partnership, if only for the tax incentives.
Additionally, even if the boat is just for fun, additional tax breaks can be provided if you make the yacht your second home. As long as you live on the vessel a mere 14 days a year and have some of the basic indications of it being a home (such as sleeping quarters, a water supply and a stove), the second-home tax breaks kick in. Furthermore, even if the boat is your part-time residence, renting it out to friends on occasion may enable you to write off all the extra fixtures and amenities in addition to things like the mortgage payments, marina rental fees and repair work.
Family Limited Partnership (FLP)
An FLP is a very legitimate way to protect all of your assets from estate taxes. The key is to focus on setting up the entity as the best way to protect your assets and manage your finances — not to find tax breaks. Making the latter too much of a priority can incur the wrath of the IRS, which has been taking a more stringent stance when it comes to abusively using FLPs. However, if it is set up right and with the right focus, you will have an effective and legitimate vehicle to minimize your taxes.
First, an FLP is just like a limited partnership where there is a general partner who controls 100% of the assets within the partnership. Family members serve as the limited partners of the FLP — and yes, even your children can be limited partners. Most commonly, in an FLP, the parents serve as the general and limited partners who pass their partnership interests to the children. Technically, once the assets are in the partnership, they are no longer officially owned by the parents — the partnership owns them, though the parents retain control because they are the general partner.
Gifting interest in the partnership to the children can often be done with enormous tax benefits. Each parent can use their unified gift and estate tax credit to pay the tax on the gift of the partnership interest. With both parents, the amount of this gift can be up to $4 million. In 2009, the limit will increase to $7 million and go unlimited in 2010 before reverting back to $2 million in 2011.
This is a little tricky, but it effectively eliminates the appreciation on the parents’ assets (such as stocks, real estate and jewelry). The savings, according to best-selling author Jeff Schnepper, can be tremendous and assuming a 40-year time frame, a $3 million transfer, and 7.2% annual appreciation, $48 million in estate taxes have been bypassed.
The other tricky part of FLPs is that any assets transferred into an FLP (or any partnership) are subject to a discount. An asset is worth less if you do not have full control over it (remember that in an FLP the partnership owns and controls the asset — not you). The discount can go as high as 40% depending on the type of asset. Things like cash tend to get a smaller discount than things that are less liquid, such as real estate. Simply put, $5 million of real assets can be transferred into the partnership without paying any federal transfer taxes and, in some cases, (partnerships with less than $2 million) may have no federal gift or estate tax liability, if the partnership is properly structured.
The taxman cometh
When someone is as wealthy as Warren Buffet, they can afford to be a little more “social” minded. But, the rest of us we would like to hold on to a few of our hard-earned dollars a little while longer. Finding legitimate ways, or even loopholes, within the system to safeguard your wealth and your family is proving to be more and more difficult, but with the tips above, the job has been made easier.
Article by: Terence Channon
Article by: Terence Channon