Can Your Family Office Navigate Tax Reform?

Daniel Krauss and Michael Morris from EisnerAmper’s San Francisco office recently held a webinar to discuss “Navigating Tax Reform and the Future for Family Offices.”

Since concerns regarding the elimination of long-term capital gains tax rates and raising individual income tax rates for wealthy taxpayers have now been nullified, family offices can now shift their focus to other important topics. 

Family offices are increasingly focusing on succession planning, reallocating assets to direct investments and private equity, and seeking tax optimization and deferral strategies as responses to inflation and rising interest rates.

Tax Optimization Strategies

Leaders of family offices with closely held businesses who are nearing retirement age and considering selling their businesses are now looking to structure these deals as installment sales to defer the income pick-up over several years. This is a viable strategy, but the family office should ensure that the buyer is liquid enough to not default on the deal.

If an installment sale is not an option, the seller should consider bunching charitable contributions in the sale year because the charitable limitations will be higher due to the increased income.

Another tax optimization strategy during a down market is to focus on pre-tax dollar retirement plans. The dip in the market provides a good opportunity to convert pretax retirement accounts to Roth IRAs. Taxable income with respect to the conversion would use the fair market value at today’s values, which are currently much lower. If a taxpayer is living in a state with no income tax when the conversion is made, no state income tax will be paid upon conversion. Furthermore, the beneficiaries will ultimately receive this money tax-free. Roth IRAs have a built-in benefit in that no required minimum distributions are required as there are with traditional IRAs.

Income Deferral Techniques

One of the biggest deferral techniques family offices are using is in the real estate market. Qualified Opportunity Zone (“QOZ”) funds provide a deferral of tax on capital gains for federal income tax purposes, but only if certain criteria are met. Note: Some states (including NY) do not conform to the federal treatment of QOZ funds.

Family offices are also concerned about the state and local tax benefits, which have been capped. To help individuals recoup these lost tax benefits, nearly half the states have enacted the pass-through entity (“PTE”) tax. This tax is fully deductible for federal tax purposes, and some states either allow the taxpayer to claim a credit or exclude the income. Each state has different rules, so it is imperative to understand the tax implications for each state.

Succession Planning

Wealth transfer is a major focus for family offices during succession planning. Some have already done some trust and estate tax planning as well as taken advantage of the increased lifetime exemption amount. If this has not been done, it is imperative to revisit wealth transfer planning before this exemption is reduced. The fair market value of assets (family limited partnership interests) is lower in the current market, and you can still use valuation discounts when determining these values. These advantages, coupled with the increased lifetime exemption, provide for significant transfer of wealth free of tax.

Using a charitable lead annuity trust is another way to transfer wealth if you have already exhausted the lifetime exemption. The grantor establishes a trust for the benefit of a public charity and gets an upfront charitable deduction when the contribution is made. Fixed annual payments are made to the public charity over the term of the trust, which allows the assets to grow in value. The remainder interest can be transferred to the heirs gift-tax free. Since interest rates have risen over the past few months, this might not be as beneficial as it was earlier in the year.

Private Equity Investing

This area is challenging for family offices with larger allocations for private equity investing. These types of investments are generally longer term with close-ended funds that provide for a greater rate of return. This long-term investment may cause cash flow issues if the proper financial liquidity forecasting is not done. To make informed investment decisions, family offices should use a capable reporting system to obtain accurate, real-time information.

Another great opportunity in private equity investing is IRC Sec. Section 1202, qualified small business stock. There are several requirements to be met to qualify for this benefit, which allows you to exclude the capital gain on the sale of this stock if held for five years or more. This exclusion is the greater of $10 million or 10 times the price of the stock when originally purchased.

With tax reform a seemingly ever-present possibility, it is important to take advantage of the benefits still available. Working with a qualified tax advisor can provide you with opportunities that could result in significant tax savings.