Archive for Retirement

How to Shift Corporate Ownership and Save on Taxes

It pays to plan ahead in almost any situation in life, and the future of your corporation is no different. You have multiple options for what to do with your business when you’re ready to step aside, but we’re going to focus on one in particular that provides you with a nice tax-saving strategy. In a private letter ruling, one man who owned 100 percent of his company’s stock was able to gift some of his stock to his children and then sold the rest to his corporation.[1] The great news is you can use the strategy with anyone—not just your kids.

Here’s how it worked for him:

  • He had a third-party appraiser determine the per-share value of the corporation.
  • His two children wanted to own and run the company, so he gifted shares to each of them.
  • Right after that, the corporation redeemed the remaining stock, providing the man with cash and a promissory note. This last move is important because it means that the children then owned 100 percent of the corporation and the father had the promise of future payments, as well as immediate cash.

What It Means in Terms of Taxes

In a situation like the one above, the recipients are not subject to any taxes for the gifts. The previous owner may be subject to taxes, depending upon how much each of the shares was worth. You pay no gift taxes for amounts less than $14,000 in 2014.[2] Anything over that amount dips into your estate tax and lifetime gift tax exemptions.[3]

Now, another thing to consider is how you will be taxed. You want to be taxed at the tax-favored capital gains rate for selling the stock to your corporation. In order to make this happen, you’ll need to file the right IRS-required elections for complete termination, as well as those that will allow you to avoid stock attribution rules on the shares given to the gift recipient(s).[4]

Without the termination election, you will be subject to taxes at the dividend rate, and you would receive no offset for your basis. Capital gains, on the other hand, are offset by your basis so that you are only taxed on the net gain. In addition, the cash plus promissory note combination is an installment sale, meaning the taxes will be paid on the cash only in the first year, and then tax payments will be made each year after that on the gains and interest received. As for the corporation itself, it will be able to deduct the interest it pays on the promissory note.

Of course, you should check the applicable mid-term minimum federal interest rates for such situations.[5] These rates can be used for your calculations when planning your retirement strategy. Also, you’ll want to use appropriate rates when you establish the promissory note.

In summary, by using this particular strategy for shifting corporate ownership, you’ll get up-front cash, interest on the promissory note, and tax-favored capital gains treatment on taxes. The recipient or recipients of your business have no tax burden on the transaction, and the corporation gets to deduct the interest payments made to you on the promissory note. This strategy works well if, like the man in the private letter ruling, you plan to transfer your corporation to your children. But, it works just as well for transferring the company to an employee, colleague, or current shareholder. Exiting your business should be planned just as carefully as every other decision you have made along the way.

  1. Private Letter Ruling 201228012
  2. IRC Section 2503(b); Tax Foundation
  3. IRC Section 2010(c)(3); Tax Foundation
  4. IRC Section 302(c)(2)(A)(iii) as specified by Reg. Section 1.302-4(a)

Selling a Piece of Real Estate? You Don’t Have to Pay Taxes, Even if You Don’t Use Section 1031

Overpaying taxes puts a damper on anyone’s mood. You should be paying precisely what you owe—no less, and no more. When it comes to selling your real estate, you really don’t have to pay taxes on that sale right away. One way to avoid the taxes is by using a Section 1031 exchange, but you actually have other options. This article will show you how to take advantage of them.

Option 1

With this option, you combine the strategies of creating a charitable remainder and a wealth replacement trust rather than selling the property. Then, voila! You don’t have to pay any taxes. Here are the steps:

  1. Create a charitable remainder trust and donate the property to the trust. With the donation, include terms that grant income to your and your spouse for the remainder of your lives. This can be either a percentage of the trust income (charitable remainder unitrust) or a fixed income (charitable remainder annuity trust).[1] The former type can accept future property donations to the trust.
  2. In the trust, designate one or more charities to receive the remainder of the trust’s balance upon the death of the second spouse.
  3. Establish a wealth replacement trust. This is a term-life insurance trust. It should include a second-to-die policy so that both wife and husband are covered. The trust acts as the insurance policy applicant, owner, and payer of premiums.

How does this option save you money? First, you avoid paying taxes on the sale of the property, which would have reduced the amount available from the proceeds for future investments. Second, you’re able to deduct the charitable expenses right away. Of course, you will be subject to the limits on charitable donations. However, if you exceed that limit for the current tax year,[2] you can carry the remainder over for the next five years.[3] Additionally, you get a tax write-off on the remainder interest that you gave away to the charity. Tax law includes expectancy tables to calculate this value, which is the value of your charitable contribution.[4]

This strategy also has another benefit, which comes from establishing the wealth replacement trust. You see, this trust receives the insurance proceeds when the surviving spouse passes away. The trust then gives those proceeds to the heirs, so you increase what is left for your children.

To sum up the benefits of this combined strategy:

  • You don’t pay capital gains taxes for transferring the property to the charitable remainder trust.
  • You invest at the pre-tax value rather than only have the after-tax amount to invest.
  • You get a deduction for your charitable donation.
  • The trust provides income to pay the insurance premiums.
  • Your heirs receive a significant amount of money.
  • You benefit your favorite charity, your heirs, and yourself, and pay nothing (or close to nothing) in taxes.

What kind of numbers are we talking about? If your real estate is worth $1 million and you sold it, you would pay $300,000 in taxes. You could then invest the remaining $700,000 in CODs (at 2 percent interest) and make $14,000 annually, pre-tax. But, with the charitable remainder trust strategy, the trust sells the real estate for $1 million and sets up a 5 percent return for you in the charity’s investment portfolio. In this scenario, you get a $94,000 deduction for the donation, plus annual income of $50,000. You can then pay $15,000 per year from that $50,000 for a $1 million life insurance policy with your children as the beneficiaries. Which do you think is the better deal?

Option 2

Another option for business-savvy individuals is to use Section 721, which involves transferring the property to a partnership. Section 721 negates any gain or loss (to you, the partnership, or its partners) when you contribute property and get partnership interest in return.[5] One way to do this is transfer your real estate to an operating partnership (OP) of a real estate investment trust (REIT). The REIT then acts like a real estate mutual fund with diversified holdings. Since you receive OP units as part of the exchange, you are then entitled to periodic distributions of the REIT. Additionally, these units can be converted into shares of the REIT. The primary benefit of this method is that you both avoid taxes and the transfer and increase the liquidity of your investment.

Normally, when you transfer property that has a mortgage liability that exceeds the property’s basis, you trigger taxes. That’s because the excess mortgage is considered a gain. How do you avoid the taxes? You simply need to know about a special REIT called a UPREIT.[6] The UPREIT guarantees an equivalent liability portions to the REIT, making excess mortgage cease to be an issue. Therefore, you pay no taxes.

Option 3

Another way to reduce your tax burden is to use a regular installment sale to dispose of your real estate.[7] This method is also called “holding paper”, and your primary benefit is an increase in net worth by holding a secured note at a higher interest rate than you would get at a financial institution. It works like this: you pay taxes as you get paid. That means you can earn interest on the gross amount since you don’t have to pay the taxes right away.

But, you may encounter situations where you do have to pay those taxes up front:[8]

  1. If you have to recapture depreciation that exceeds straight-line depreciation, or
  2. If you have to recapture low-income or rehab property investment tax credits.

The IRS considers your disposition an installment sale if you sell the property and then receive at least one payment after the close of the taxable year in which the sale occurs.[9] The payments are comprised of three parts: 1) a taxable portion of the principal payment, 2) a nontaxable portion of the principal payment, and 3) interest.

So, how much does this help your bottom line? Let’s say you sell a piece of investment property for $250,000 after selling expenses. The property’s tax basis is $125,000, so your profit would be the remaining $1250,000. With an installment sale, you divide that profit number by the $250,000 net proceeds, giving you a gross profit percentage of 50 percent (i.e. every receipt of principal is a 50 percent taxable gain). Upon closing the sale, you receive a down payment of $30,000, which is 50 percent return of capital (from your basis) and 50 percent taxable gain.

Afterwards, you receive a payment of which $700 is principal (the rest is interest). For tax purposes, you again divide the principal into 50 percent taxable and 50 percent nontaxable. As far as that interest is concerned, you are required by tax law to charge interest at a minimum rate for installment contracts—the lower of the Applicable Federal Rate (AFR) or 9 percent. The AFR is published monthly by the IRS.[10] To get the most from your installment sale, keep an eye on the interest rates and wait until you can get a higher rate. Then, add points to the interest rate if you can.

When selling your real estate, it’s usually best to avoid paying up-front taxes. The 1031 exchange is an efficient way to do this, but it only works if you plan to replace the property in order to continue building your real estate portfolio. In contrast, each of these options is a strategy to reduce or completely get rid of the taxes you would pay upon sale. This leaves you with more money to invest and grow in other opportunities. When it comes to real estate, you always have choices about when to pay taxes or even whether to pay them at all.

  1. IRC Sections 664(d)(1-2) and 453(b)
  2. IRC Section 170(b)(1)(A).
  3. IRC Section 170(d)(1)(A).
  4. Regs. 20.2031-7A(f); 1.664-4.
  5. IRC Section 721.
  6. IRC Section 357.
  7. IRC Section 453.
  8. IRC Section 453(i).
  9. IRC Section 453(b)(1).
  10. IRC Sections 483 and 1274; IRS Publication 537 on Installment Sales (2008), page 10

How to Reduce Your Taxes with a Win-Win IRA Strategy

You know the deal with a traditional IRA. You put your tax-deferred money in and breathe a sigh that you didn’t pay taxes on that income. However, looming over your shoulder is the knowledge that eventually, you will pay big for the withdrawal of those funds. Is there anything you can do to minimize the impact?

Yes. The best thing to do is not to put off planning your IRA tax strategy and do something now to reduce your future tax burden. Instead, start paying something now. Why? You should do this because certain years are better than others for paying extra tax. You see, certain circumstances allow you to have additional taxable income but not actually pay any more in taxes. Here are some scenarios:

  • You can offset your income with losses;
  • You fall into a lower tax bracket than usual this year because of less income from other sources;
  • The current year’s tax rates are lower overall; or
  • Some of your investments lose value, such as in a downturn in the stock market.

You may think it would be hard to know when these scenarios will pop up. Fortunately, tax law itself gives you some assistance in making the most of these opportunities.

Switching between Traditional and Roth IRAs

As mentioned above, both your contributions and earnings are taxed when you withdraw cash from your IRA. Make those withdrawals when you’re in a high tax bracket, and you could be eating up your retirement savings pretty quickly. This is especially applicable if you choose to continue working after you reach retirement age. Your work income makes it more likely that you’ll be in a higher bracket. Additionally, once you reach 70 ½ you’re required to take mandatory distributions from your traditional IRA.

Unlike a traditional IRA, you pay taxes up-front with a Roth IRA. Because of this, you can convert from traditional to Roth in order to pay taxes at the most opportune time for you. Here’s the basic information you need:

  • When you convert to the Roth IRA, you will pay taxes, so make the conversion in a year when you plan to have a lower tax bill.
  • After converting, your earnings will continue to accrue and compound tax-free within the Roth IRA.
  • You can undo the conversion (or just a part of the conversion) up until October 15 of the next year, allowing you to make a strategy for how much tax to pay in that year.
  • Since you’ve already paid taxes upon conversion to the Roth IRA, you can withdraw money from it without paying any taxes again, as long as you’re at least 59 ½. This includes on the earnings you make. You will have to wait five years from your first Roth IRA contribution (for any Roth IRA in your name) to take advantage of this.[1]

So, let’s say you expect to claim a $20,000 loss on your federal income tax return this year. From your traditional IRA, you transfer $20,000 to a Roth IRA. What happens next? First, you get a tax deduction for the amount you put into the traditional IRA. Then, you pay no taxes on the transfer to a Roth IRA. Finally, once you’re 59 ½ you pay no taxes when you withdraw the money from the Roth account (again, as long as it’s been at least five years since your first ever Roth contribution).

Now, here’s the part that really reduces your risk from this strategy. You are allowed to undo the Roth conversion![2] For instance, you may have transferred funds from a traditional IRA to a Roth account because your business had been slow and you expected a low tax year (the perfect time to pay IRA taxes). However, after the conversion, it’s possible that your business takes off and your income increases.

In this case, the increased income could put you in a higher tax bracket and make it less beneficial to pay those taxes now. No problem. The IRS will allow you to undo the conversion. They also call this “recharacterizing” the conversion. Simply put, it’s like you never transferred funds to a Roth IRA in the first place. If you find yourself in this situation, just make sure you keep an eye on deadlines—you have until your next tax return is due to undo the change.

Hint: You can give yourself some time to decide whether you need to recharacterize the conversion by applying for a filing extension on your tax return. You’ll then have until October 15. Just as you can undo a conversion, you can also redo it when the time is right, but you’ll have to wait until the later of 1) 30 days after the initial recharacterization or 2) the start of the next year after conversion.[3]

Other Factors to Consider

There is another reason, aside from increased income, why you may want to undo an IRA conversion. You could experience a decline in value for your investments after you make the transfer. If you convert $50,000 from your traditional IRA to a Roth IRA, and the investments drop in value to $30,000, you’ll end up paying higher taxes than if you’d converted after the drop in value. You pay $16,500 for the larger transfer, whereas you would have only paid $9,900 for transferring the smaller amount.[4]

If your investment value drops, why would you want to be stuck with thousands of dollars more in taxes? Instead, you just recharacterize the conversion and save that extra $6,600, waiting to convert the $30,000 back to a Roth IRA once the wait period is up.

As if this strategy isn’t advantageous enough, there’s actually something else you can do to maximize your tax benefit. Do you have multiple investments in your traditional IRA? If so, it would be a smart move to convert those investments separately into their own Roth IRA.

Keeping in mind the example above about declining investments, consider the following scenario. You have a Roth IRA in which you converted two different investments. The value of one increases at the same time that the other’s value decreases. Now, you have to decide whether to undo the conversion, but both investments are tied together (i.e. you cannot undo only one). Don’t get yourself into that frustrating situation!

Instead, transfer each investment into its own separate Roth IRA. Now, when the investments perform differently, you can choose which conversion to recharacterize, giving you more control over your tax strategy.[5] Once the conversions are complete and taxes are paid, you can later consolidate the two accounts, making them easier to maintain.

Although it takes a little more careful observation on your part, you can really maximize your retirement savings by planning the best years to pay taxes on your IRA. Many people debate whether the traditional or Roth account is better (although if you only stick with one, the results are a gamble). The truth is you don’t have to gamble with how much you pay in taxes. You can, and should, decide when you are ready to pay the taxes on your retirement account.

  1. IRC 408A(d)(2).
  2. IRC Section 408A(d)(6) and (7); Reg. Section 1.408A-5(Q&A-1).
  3. IRS FAQ Regarding IRA Recharacterizations.
  4. Given a 33 percent tax rate.
  5. Reg. Section 1.408A-5(Q&A-2).