Here are two more great ideas you might be able to use when thinking about how to save money on your taxes this year. One or both of these ideas might result in some huge tax savings so you can apply the savings to other investments that would further increase the value of your portfolio. Take a look, and if either of these ideas seem appealing, schedule a visit with your financial planner.
Establishing a family limited partnership (FLP) can be very helpful with improving tax efficiency by shifting wealth to future generations. A family limited partnership allows the elder members of the family to share their assets with the family’s children while at the same time keeping control over the underlying assets in the hands of the senior family members. By transferring the elders’ assets to the children, the older family members’ estate may also benefit from a substantially reduced transfer tax.
In this arrangement, the senior family members create the FLP in the role of general partners. The children or grandchildren serve the partnership as limited partners. In the beginning, the parents hold both general and limited partner interests. The general partners keep full control over the FLP and may gift as many of the limited partner units as they wish to their children or grandchildren, reducing their taxable estate through this process.
In addition, both gift tax and the use of the applicable exclusion amount (previously known as the unified credit) can be circumvented if the annual amount transferred to each child is below the annual exclusion amount, which is $15,000 per donee in 2019. Thus, both parents could donate a maximum of $30,000 per year to each child based on the transfer limits current in 2019.
Ultimately, 99% of the FLP will be transferred to the limited partners with the general partners, or parents (grandparents), retaining only 1% of the total equity in the FLP. Because of the restriction on the amount of funds that can be annually transferred from the general partnership into the limited partnerships, it can take several years for all but 1% of the funds to transfer to the children tax-free. During this time, parents will retain their exclusive control over both the assets and the FLP because they are the exclusive general partners.
It’s important to realize that the limited partner interests have no authority over the FLP or its underlying assets, and no funds can be transferred without the general partners’ permission. Limited partners represent only a minority position and the value of their position has very low marketability. However, because the value of assets change every year, an annual evaluation of the limited partner interests should be conducted annually to avoid transgression of the IRS rules.
Aside from the benefits of decreasing the taxability of the parents’ estate and the tax-free transfer of the assets to the children, an FLP can protect the children’s assets in the FLP from creditors because the children do not control the assets in the FLP; moreover, the parents may choose to not make distributions to a child with debts.
Other benefits include, in part:
1. Providing the continuation of a business after the death of elder members
2. Decreasing the viability of individual owners
3. Allowing family members to unify their assets
4. Making estate ministration more simplified
5. Make family gifting more expeditious
6. Reduce asset management expenses
7. Protect family assets from reckless family members
Consider meeting with your financial planner to discuss the tax-saving opportunities available to your family by establishing a family limited partnership.
Top Tax Tip #6: Tax Aware Investing
Most people invest their funds with the intention of capturing the highest possible pre-tax returns. The strategy behind tax aware investing is to focus instead on the highest possible after-tax returns.
Most investors do not plan their investments with an eye toward protecting their gains from predatory taxes. This practice is beginning to change as investors realize it is not how much they earn that matters compared with how much of their gain they retain. Taxes can significantly impact an investor’s annual returns, diminishing the potential for achieving lifetime financial goals.
Tax-aware investing references the following features, in part:
1. Expanding Investments in Tax-Favored Assets: Investment assets can be taxed at different rates. For example, high income investors pay 40.8% tax on interest, 23.8% on gains made from stock sales, and 0% tax from income derived from tax-exempt bonds. This suggests investors might benefit from shifting their investments to asset classes that favor low taxation. The intention is not simply to reduce taxes but rather to increase after-tax return. Of course, each investor’s circumstances are unique and must be carefully considered to improve the likelihood of the desired outcome.
2. Deferring Asset Gains for Later Distribution in a Lower Tax Bracket: Assuming all factors are equal, usually a portfolio’s turnover ratio attracts less taxes when the ratio is lower than when the turnover ratio is higher. Knowing that a lower turnover ratio is subject to less taxes infers the value of establishing a passive buy-and-hold strategy. This can be accomplished by investing in assets like tax-efficient mutual funds, index funds, ETFs and SPDRs because these assets typically have low turnover ratios. Keep in mind that total turnover is not the most effective measurement of tax efficiency; it’s the net turnover that produces the desired result of asset retention.
3. Reorganizing Portfolio Construction to Benefit from Lower Taxes: When constructing a portfolio that seeks to maximize after-tax return, compared with maximizing the usual pre-tax returns, the intention is to achieve both pretax alpha and after-tax alpha. The core of the portfolio will be most effective if it contains low turnover assets such as tax efficient mutual funds, SPDRs and ETFs, and stocks that are passively managed as all of these assets usually minimize taxes. With this set as the core, the fund manager can create satellite portfolios that focus on beating the market. This strategy could be an advantage because satellite portfolios such as these are usually volatile and likely to produce large capital gains and large capital losses. By using the capital losses to offset the capital gains, the portfolios may show positive pretax and after-tax alpha results.
4. Sensitivity to Income, Gains and Losses Based on Tax Bracket Positions: As discussed previously, shifting gains and losses into deferred or distribution status based on your current or future tax bracket is a tax prevention or tax diminution strategy that could save your tax expenses in a given year. Distributing gains in low tax bracket years and deferring gains during high tax bracket years is a well-recognized practice.
5. Tax Sensitive Asset Location: To minimize total taxes, a savvy investor needs to distribute his or her assets across the range of taxable accounts, tax-deferred accounts like traditional IRAs and 401(k) plans, and tax-exempt accounts such as Roth IRAs and Roth 401(k) accounts. Ranking your assets by their tax efficiency will help clarify which assets need to be shifted into tax-deferred or tax-exempt status so your assets are subject to tax at a lower rate or not subject to taxation at all.
Tax aware investing is rarely a large part of the investment process for most investors who focus, perhaps errantly, on achieving maximum pretax return but then leave themselves potentially open for tax predation. By being more attuned to the value of an investment portfolio after taxes have been assessed is likely to change an investor’s focus more toward preserving the portfolio’s gains rather than surrendering an unnecessary excess to the IRS.
We would welcome hearing from you about the strategies just presented, as the financial services we offer include these and many other tax-saving options. At Synergy, we continually work on your behalf to increase your wealth and reduce your risk. Please contact us for a consultation that could be highly beneficial for your portfolio. Thank you!
Joseph M. Maas, CFA, CVA, ABAR, CM&AA, CFP®, ChFC, CLU®, MSFS, CCIM
Synergy Financial Management, LLC
13231 SE 36th Street, Suite 215
Bellevue, WA 98006