On-Demand: Family Offices | Navigating Tax Reform - and the Future
Join EisnerAmper for a discussion on how you can prepare for the coming years from a tax perspective. Amid tax reform concerns, you’ll learn strategies to put your best foot forward in 2022 and beyond.
Michael Morris:Thank you, Astrid. Again, my name's Michael Morris and I'm with EisnerAmper. Welcome to our webinar; Family Office Navigating Tax Reform In The Future.
Michael Morris:Thank you, Astrid. Again, my name's Michael Morris and I'm with EisnerAmper. Welcome to our webinar; Family Office Navigating Tax Reform In The Future. A little bit about our firm EisnerAmper is a top 20 national accounting firm and business advisory firm headquartered in New York City. We have a very significant family office practice of over 400 family offices that we work with in real estate, private equity deals. We have family office solutions and a wide array of advisory and accounting services. I'm honored to have Dan Krauss with me, who's a friend, a colleague, and a new partner, as of this morning, with the firm. I'm going to have Dan, who's going to be answering all my questions here, introduce himself, Dan, take it away, buddy. Congratulations on your partnership.
Daniel Krauss: Thanks Mike. Very much appreciate it. Everybody, I work out of the California office as a tax partner, as Mike mentioned, I've been working in public accounting for about 15 plus years in the family office space. If you can't tell from my accent, I am a New York transplant, although I try to hide it. My wife and I moved to the Bay Area in December, 2019, right before the pandemic. We're loving it out here on the West Coast.
Michael Morris:Well, and we love having you, Dan. We're glad you're here. Your wife's lovely. You didn't mention Miles, your new baby. Congratulations on that as well.
Daniel Krauss:Thank you very much. He just turned four months on Monday.
Michael Morris:He's cute. He was in the office the other day. That's lovely. Dan, what are some of the trends you're seeing with your family office clients?
Daniel Krauss:That's a great question, Mike. If you had asked me this question a couple of months ago or a year ago, for that matter, I would say the looming tax reform that was on everybody's mind, with respect to really coming after the wealthy, which was really defined as folks that were earning $400,000 each year or above, as a married couple. As a result of what the Biden administration was planning on doing, they wanted to eliminate long term capital gains rates for those folks. You're talking about 20% rates going away on stock sales and they wanted to also raise the individual income tax rate from being 37% to 39.6%. All those concerns have now been nullified based off of the most recent proposal that got passed by the Senate. So at this point, from an individual income tax perspective, there really isn't much to worry about regarding tax reform as far as increases to tax rates.
As of today, I would say the three most significant trends would be a increased focus on succession planning for the next generation, a reallocation of assets under management to direct in investments in private equity. I think everybody could agree with this, folks are really looking for a combination of tax optimization and deferral strategies in response to both inflation and rising interest rates.
Michael Morris:Based on the trends you've just described, what are some of the tax optimization strategies that you've been using, other than what you just mentioned, for your family office clients?
Daniel Krauss:I have a lot of folks that have closely held businesses. In several instances, those folks are nearing retirement age and they're considering strategies to sell that business because they don't necessarily have heirs to pass that business on to. For those folks, prior to the announcement that was made with regard to this inflation reduction act, which we'll talk about a little bit later today, my answer would've been different, which is that if you were to sell your business the way you would negotiate the deal, you would want to try to get everything up front so that you can lock in favorable long term capital gains rates. That way, if tax reform did come down the pipe, which at one point was retroactive possibly, you wouldn't have to worry about having that capital gains rate be eliminated.
Alternatively, now that we're in an environment where it doesn't look like the long term capital gains rates are going away anytime soon for individuals, one strategy that could be looked at would be structuring the transactions so that you sell your business for a note and you get a series of payments over multiple years. By doing this strategy, which is called the installment sale method, you're able to defer the recognition of all your gain in year one. That way you're really eliminating the effects of having a big tax bill to pay. It's a great strategy to think about in an environment where we don't have to worry about these rising tax rates.
On the flip side, it's important to note that if you're going to enter a deal like this, where you're considering an installment sale, you really want to make sure that the buyer is going to be in a position where they'll be liquid enough to make these series of payments and they're not going to default. Because if they default clearly the upfront tax savings that you're going to recognize won't mean much, if you're not getting the full freight of payments, that will be due to you based off of this transaction.
With that being said, if having this liquidity event is unavoidable and the installment sale method is not something that you feel comfortable in negotiating, for the folks that are charitably inclined, if there's a way to anticipate the year in which you're going to sell your business, my recommendation would be to try to bunch your charitable contributions together into one year with respect to the year of sale. That way you're getting a larger tax benefit for the charitable contributions that you're going to be making, as opposed to just making your regular contributions on an annual basis.
The last strategy that I want to bring up, which I think is really important to note, especially because I don't think anybody really wants to look at their stock portfolio right now, is with respect to anybody that has a retirement plan with pre-tax dollars. When you're in a down market now is a good time to think about potentially converting those pre-tax retirement accounts into Roth IRAs. Why would you do this? Well, number one, the taxable income, with respect to this conversion, would be the fair market value of the retirement account in today's dollars. You're going to be locking in today's tax rates at a lower value, which could be very advantageous for folks and it could be the silver lining that people need when their stock portfolios are down, significantly.
Another thing to consider is that by converting today, if you're living in a state with either no income tax or a lower income tax rate, when compared to your account beneficiaries, this could also be a very good way to lessen the blow of a tax bill that eats into the principle of your retirement account that will eventually get inherited by beneficiaries.
Lastly, I would say the final two points with respect to this that I want to mention is that by converting into a Roth IRA, you're not going to have any RMD requirements on a go forward basis. To be clear, an RMD stands for a required minimum distribution. Once you reach retirement age, which now is for folks that are turning 72, with pre-tax accounts you're required to take minimum distributions on an annual basis. Then lastly, I would say the biggest upside of converting to a Roth IRA is that when it comes time to actually take distributions out of the account, with respect to the beneficiaries, all of the principle and appreciation in that account is going to come out tax free to them.
Michael Morris:Excellent. Excellent. Now we are starting to get questions, but we're going to have a little portion at the end for those questions. Mitchell, we'll get to your question at the end. We just want to get through our presentation, if you don't mind. Then we'll jump into that. We're actually asking our kids to get Roth IRAs is put together. They're out of college and in their first professional job and they're contributing to their 401(k)s, but we're also asking them if they want to consider putting some money into a Roth. I think it's a good strategy. Thank you for that. Are there income deferral techniques that you're implementing with your family office clients?
Daniel Krauss:I would say the biggest deferral technique that my clients made a serious run on, over the past couple of years, is in the real estate market, with respect to something called a qualified opportunity zone fund. Just the shorthand, which we'll be speaking about now, we'll call it a QOZ. When you're looking at a QOZ, the intent of that tax regime was to essentially drive businesses and real estate investments towards low income and, or economically distressed areas across the country. Investors were incentivized to do this, because any capital gains from a major liquidity event could become tax deferred for federal tax purposes, when you invest into a QOZ fund, as long as certain criteria is met by the taxpayer and the fund. With that being said for anybody that is a California resident, that's on this call, unfortunately, California does not conform to this federal regime. You're still going to have to pay your fair share to California.
With that being said, a couple of other important things to note about this type of investment, that I think everybody would be interested in hearing, if you have a liquidity event from a stock sale, the timing of when you have to invest your money, which is not going to be based off of the gross proceeds from the sale, it's going to be based off of the gain realized from the sale. If you have a $100,000 gain and you want to give a deferral, you have to invest $100,00 into a fund. The timing of that investment starts from the date of the sale and you have six months to do so, or 180 days. That's for direct investments in stock.
For any sort of liquidity events that are happening through, for instance, a partnership investment, the timing on when you have to make the investment is a threefold approach. You can either find out exactly when the liquidity event occurred in the partnership and specifically identify that date. You have 180 days to make the investment from said date. Option number two, you could go based off of the calendar year of December 31st and go 180 days out from there. Option number three, you go off of the original due date of the partnerships tax return. Typically, that's going to be March 15th. You go 180 days out from March 15th and that's how long you would have to assess your situation and determine if it makes sense for you to make an investment into one of these funds.
Lastly, I would say the biggest benefit, outside of the deferral aspect at this point, that's available to any taxpayer that's going to invest into these funds starting in 2022, at this point, because there's other benefits that are no longer available, so we won't talk about them, is that if you hold the investment for a specific period of time, when your investment gets redeemed, that investment comes out tax free, similar to a Roth IRA strategy. All the principle, all the appreciation comes out tax free. The only thing that you have to be aware of, that you're going to be paying taxes on, which is very important to note, is going to be that for any gross income that you're deferring, the tax bill on that gross income, so in our example, we said $100,000 that tax will come due by December 31st, 2026.
Michael Morris:Okay. Very good. Very good. It's so funny. We have so many clients that have QOZ funds, so it's very interesting to approach it from the investor side. Since 2008, a large contingent of attendees, on our program today, have limited to a tax deduction of 10,000 on their federal income tax, respect to state income taxes and property taxes. What planning are you doing for your clients to make up for the lost tax benefit?
Daniel Krauss:There wasn't a lot that we could do with respect to that loss benefit until recently. At this point, nearly half the states in the country that have a state income tax have enacted something known as an elective pass through entity tax, which we'll call PTE tax. This elected PTE tax is a mechanism to help individuals recoup the lost federal tax benefit that they're getting resulting from being capped at $10,000 on state income taxes and property taxes.
To just give everybody on the call, a little high level understanding of how the PTE works. Typically, if you're an owner of either a partnership or an S corporation, that pass through entity can make an election on the owner's behalf to pay an entity level tax. Once that election is made and the PTE tax gets paid by the pass through entity, on behalf of the owner, the PTE tax can be fully deducted for federal tax purposes against the taxable income that gets allocated to each owner. At the state level, an owner will either be allowed to claim a credit against their income tax liability, or they'll be able to exclude their distributive share of income from the elective pass through entity that paid the PTE tax on their behalf. It's a very powerful tool, with respect to completely eliminating the $10,000 salt cap for anybody that's an owner in a pass through entity that has a material amount of taxable income that gets allocated to them on an annual basis.
Michael Morris:Does California offer this PTE tax benefit to the taxpayers, that are subject to California personal income tax?
Daniel Krauss:Mike, they do, but similar to what we were talking about with respect to QOZ funds, California likes to make things very difficult for people. Basically, this law was first enacted in July of 2021. There were two major flaws with the bill. Number one, the bill limited a significant number of entities that would actually be eligible to make the PTE election, which clearly shouldn't have been the intent of the bill if we were looking to make sure that everybody that was an owner would have access to eliminate this $10,000 salt cap. The second issue at hand with this bill is that it imposed the floor on how much credit could be used to offset an individual's California state tax liability on an annual basis. By creating this floor, this essentially created doubt as to whether or not a credit could be fully utilized, because basically with the way this law worked originally, after this flaw if you had a credit that got loud in year one, you could carry that credit forward for up to five years. If you couldn't use the credit within five years, you lost the opportunity.
As a result of the way the legislation was originally written, we advised a lot of our clients to not make the election, because it really wasn't beneficial for them as a result of these two major flaws. As a result of that, there were a lot of complaints and lobbying from tax practitioners like myself, to the FTB. Eventually, legislation was passed in February of this year to essentially fix their mistakes, which was a major windfall for anybody that is a taxpayer subject to California personal income tax. Basically, how's the law written now? That's what everybody wants to know. First off, the law that was passed is effective for tax years beginning on January 1st, 2021. A pass through entity, you can make an election on behalf of the owners to pay an entity level tax of 9.3% on the owner's distributive share of both income and guaranteed payments that are subject to California personal income tax.
As far as an example, just to quantify this, if a taxpayer has a million dollars of income, there'd be a flat tax rate of 9.3%. Therefore, you would be making a payment of $93,000. If your affected federal tax rate is 37%, that would yield approximately a federal tax benefit of $35,000. It's an extremely powerful tool. Just a couple of other things to note about this legislation, for 2022, in order to actually participate in the regime, you needed to make an installment payment by June 15th. If you didn't make the installment payment by June 15th, you can't participate in this regime for 2022, which kind of stinks, but that's how the law was written.
Basically, if you're wondering what is that installment based off of? There's two ways that this works. Number one, if you didn't make the election in 2021, and you filed your tax return and you didn't wait for the legislation to get amended, then at this point, all you would've needed to do was make a payment of $1000 by June 15th. That's the easy way. The hard way, which is typical of California, is that if you did make the election in 2021, you now need to ... By the way, there's plenty of partnerships and S corporations out there that are still on extension for 2021. The returns aren't due until September 15th.
For some taxpayers, their books still aren't closed yet for 2021 and they don't actually know what their tax liability is. If they did make the election for 2021, they may not necessarily know what their actual tax liability is yet, with respect to the PTE tax. For them, they needed to make an installment by June 15th that would be the equivalent of 50% of their 2021 PTE tax. The problem here is that if you're on extension and you don't know exactly what your PTE tax liability is going to be for 2021, you move forward, you calculate the installment of 50% off of that estimated amount for 2022 and then it turns out that you underpaid the 50% installment amount. Based off of how the law is written today California will say, "Sorry, you lost. You can't make the election for 2022, because you underpaid the installment amount." We've been advising our clients to make sure that you overpay the 50% installment obligation, if at all possible.
Michael Morris: Yeah. I like that. What consideration should be made before making a PTE election?
Daniel Krauss:That's a great question. Number one, if you own a multi-state business and you're considering making an election outside of your home state, you'll want to confirm that your resident state allows a credit to be claimed for the PTE taxes that are going to be paid to the other state. Otherwise, this isn't going to work too well for you. Number two, clearly there has to be multiple entities, or I should say multiple owners, otherwise you wouldn't have a partnership. Yeah. You can obviously have a single owner for an S corporation, but for a partnership, you have to have multiple owners. If you're in that structure in a partnership or an S corporation with multiple owners, and there are certain owners that, for instance, don't want to participate in this election, it's very important that you determine whether or not your state requires unanimous consent with respect to this election. Because if unanimous consent is required and some owners don't want to make the election, then clearly everybody has to talk to one another to reach a general consensus on what the entity is going to do for the year.
Number three, which is also super important. The PTE rules that we're discussing today are very high level. For whatever states actually have these rules, the states are not consistent with how they apply the PTE tax legislation. It's very important for folks on this call to speak to their tax advisors about the nuances of the specific state in which you're considering making this PTE election.
Michael Morris:Basically, what you're saying is call us.
Daniel Krauss:Pretty much. Call me.
Michael Morris:We will help you.
Daniel Krauss:We would love your business. Give me a call.
Michael Morris:Exactly. Exactly. All right. Dan, you mentioned succession planning earlier. What role have you played in this process as a tax advisor?
Daniel Krauss:Most of the clients that I work with have done quite a bit of wealth transfers through trust and estate planning when the lifetime exemption amount was $5 million over 10 years ago, and they haven't done much planning since. Just to be clear, when we talk about the lifetime exemption amount, that means the amount of wealth that you can transfer to a beneficiary without there being a gift tax consequence to you at the time that you make the transfer, for anybody that is unfamiliar with that terminology on the call. Starting in 2018, this exemption was increased over $11 million and in 2022, the magic number right now is approximately $12.1 million, with the possibility that with the way the current laws are written, that this lifetime exemption amount might drop back down at some point to $5 million. Many of my clients with taxable estates have now at least revisited the idea of additional wealth transfers, before it's too late.
Michael Morris:What transfer techniques have you seen in the marketplace lately?
Daniel Krauss:Most of my clients are structured in a way where they have a family limited partnership in place and the assets that are in this partnership are mainly publicly traded securities, as well as alternative investments in private equity and hedge funds. With the way the market is right now, even though nobody wants to look at their accounts, now is a great time to rush, to do additional wealth transfers with respect to your limited partnership interest, because you're going to get ... A, you're going to get evaluation discount and B you're going to get a further discount just based off the fact of where the market's at today. I have a lot of clients that are really rushing to do that.
Michael Morris:All right. What wealth transfer strategy is available for taxpayers that have maxed out their lifetime exemption amount and don’t want to pay gift taxes on an additional wealth transfer? Do you have any strategies around that?
Daniel Krauss:I do, Mike. I come prepared, because I don't know about you, but I'm a visual guy. Sometimes when there's new tax topics that I'm trying to learn about, and there's some expert speaking about it and they don't have any slide as a visual aid I zone out and I don't know what's going on. I've prepared a slide for us today for us to look at, that I think will shed some light on this strategy. Just to preface this, the strategy is called a charitable lead annuity trust, also known as a CLAT. Give me one moment while I pull up this slide and we will talk about it all.
I think it should be coming up.
Michael Morris:It's up.
Daniel Krauss:Okay. Perfect.
What we're looking at here, with this particular strategy, is that you're going to have a grantor, i.e. an individual. They're going to set up a trust for the benefit of a public charity, and the trust is going to be considered a grantor trust. For anybody that isn't familiar with the grantor trust aspect of things, it's just a fancy way for saying that the trust is not separate from its owner and, therefore, any income tax is paid by the granter of the trust, as opposed to the trust itself, which would be considered a non-grantor trust.
Step one, set up the trust, make it a grantor trust, make a public charity the beneficiary. There's got to be a term life to this trust. In my experience, the term lives for these trusts have been between 10 and 15 years. In the example that we're looking at on my slide here, we're looking at a 10 year trust term. Moving along with the example, based off of this 10 year trust term, the next thing that's going to happen is that the grantor is going to contribute a combination of cash and, or appreciating assets, could be marketable securities could be something a little bit more illiquid. That goes into the trust in year one.
In year one, as soon as that contribution is made, if we make this very simple and just say it's cash an in our example, here on the slide, we're contributing $5 million in cash. The taxpayer is immediately going to get a $5 million charitable deduction on their individual income tax return. Okay? The kicker is that while you get the 10 million, I'm sorry, the $5 million write off in our example here, the cash stays in the trust and gets paid out to the charitable beneficiary that you designate over this 10 year term. There're fixed annual payments made over the term. Obviously, the benefit of making this as an annuity is that the initial $5 million that you've put in has an opportunity to grow over that 10 year term so that while the annuity payments are fixed, as long as you have enough appreciation over that 10 year term, there's going to be something remaining at the end of the trust term, which is why it's important to consider putting in, not just cash, but assets that we think are going to rapidly appreciate over the same term.
Why is this important? Look at the example here. I have two slides that we're looking at. The first slide we're looking at where rates were in July, 2020. To the right we're looking at where interest rates are as of July, 2022. You put the $5 million in, and for 2022 you've got to make annuity payments of about $604,000 to the charity. You have a rate of return of over $2 million, which equates to 6% per year after tax. At the end of the day, you have a remainder interest, that didn't go to a charity, of about a million bucks. Why is this important? Because with the million bucks, you can take that money and that could transfer to your heirs, gift tax free. If you have no exemption left, this is a very, very valuable tool to give yourself an upfront income tax deduction. Wait the 10 years, do the wealth transfer and not have any sort of gift tax consequence.
The reason why I've put down a slide here where we're showing July, 2020 to July, 22 is because interest rates have increased substantially from 2020 to 2022, at this point. As you can see, under the same conditions, as far as $5 million in principle with a 6% annual rate of return, the annuity payments are much larger to the charity in 2022 because of the rising interest rate. Therefore, instead of having a remainder interest of over 2.1 million, if you did this back in 2020, you now have a remainder interest of a million. Interest rates are probably going to get hyped up again before the end of the year and so it's very critical to, if you're considering this strategy, speak to somebody soon. That way you'll actually have a remainder interest that will successfully pass to your heirs.
Michael Morris: Very good. A nice diagram too, by the way.
Daniel Krauss:Thank you. I'm going to take off that diagram.
Michael Morris:I like that visual.
Daniel Krauss:I'm going to take off the diagram because I don't know ... Maybe people got a headache after looking at that after a while, but hopefully it helped a little bit.
Michael Morris:No. I think it was very good. Very good. All right. Let's talk private equity. Probably the last five years there's been this focus into private equity. What are the challenges you see in family offices that are facing allocations of larger percentages of their capital into private equity investments?
Daniel Krauss:Generally speaking, these investments are made with the long term in mind as growth potential can be substantial, which I'm sure some people on this call could probably attest to, that have been operating in this space for a number of years. These funds they're closed ended and therefore there's restrictions on where they could be transferred for a certain period of time that investors must adhere to. As a result, family offices that are allocating a larger percentage of their capital towards these types of illiquid investments could face cash flow issues if the appropriate financial forecasting isn't in place.
Michael Morris:What advice are you giving your family clients that have these liquidity concerns, Dan?
Daniel Krauss:That's a great question, Mike. I work with a group of financial advisors that specialize in helping their clients liquidate heavily concentrated positions in private investments. Generally speaking, my role is to make sure that my client is connected to the appropriate specialist in this area. Then, all I'm doing is sitting back, waiting for the wealth advisor to come up with their strategy and then my job is to just advise my client on the tax ramifications for implementing that strategy. Really, it's the advisor that's doing most of the day lifting and not myself. The other important area to look at here is what current financial reporting system does a family office have in place. As these types of private investments multiplied and becoming more sophisticated, having timely inaccurate reports are probably of the most utmost importance for budgeting purposes, to better understand investment performance and to properly evaluate investment decisions.
Michael Morris:What tax planning opportunities should family offices be aware of, when making these private equity investments?
Daniel Krauss:I would say the biggest opportunity that I can think of is something called Section 1202, it's a federal tax benefit. This is what we call qualified small business stock. We're not going to get into all the nuances of what this code is. We're going to go very high level here. Number one, the company at play here has to be a USC corporation. That's number one. Number two, generally, you've got to acquire the stock of the company through original issuance. In some cases, gifts as well. But the gift are also obviously needed to acquire the stock via original issuance if it starts with them. Another thing is that there's certain types of businesses that are not eligible for this tax treatment. It's very important to be aware of the business type in which you think you might see this benefit apply.
Next question is what the heck is 1202? What does it mean? Very good question. The way this works is that it ... Yeah, I know Mike. You were wondering. You're on the edge of your seat. With the way this all works, assuming that you're an early stage investor in a private investment that meets all this criteria, if you hold the investment for five years or more, and all of a sudden the investment pops, there's a huge liquidity event and you have this huge capital gain, you don't know what to do with it. Under 1202, you can exclude this gain up to the greater of 10 million or 10 times what you originally paid for the stock. It's a very, very, very effective tax savings tool, assuming that you do all the upfront planning with your tax advisor. Got to throw that in there. You want to talk to your tax advisor.
Michael Morris:Call us up.
Daniel Krauss:Of course, Mike, I've got to throw California under the bus again.
Michael Morris:Please do.
Daniel Krauss:California, as I'm sure a lot of people are guessing, does not conform this Section 1202. So while it's incredible that you get this great federal tax benefit, California doesn't care, they want you to pay the share of taxes that they're entitled to. That's just how it is.
Michael Morris:We're very unique out here on the left coast.
Daniel Krauss:So I have experienced so far, in my short time here.
Michael Morris:Hey, welcome to California. All right, Dan. That was fantastic. We've basically gone through our presentation. Now, we have what seems to be quite a consistent flow of questions. I hope we can get to them all. Appreciate everybody being on here. But the first one, I'm just going to read it off here. My family office My family office was structured as a C corporation, should I consider converting to a partnership based on the proposed corporate tax legislation listed in the Inflation Reduction Act of 2022?
Daniel Krauss: don't know if I can give out this tax advice for free, but I'm going to do it. I'm going to do it because everybody took time out of their days to come onto this webinar, so we'll give you a sliver of advice here. Number one, I've got to plug our national office. Our national office put out a great article earlier this week that summarizes all of the proposed legislation in this bill. I believe that there should be a link that's posted somewhere here for people to access that particular article. That's number one. I got my plugin.
Number two. As far as this legislation is concerned, based off of what we know as of today that the Senate voted on, the legislation is going to impose a minimum tax of 15% on corporate taxpayers whose average annual adjusted financial statement income exceeds $1 billion over any consecutive three year period. I think a lot of people on this call probably don't meet that criteria as far as having $1 billion of book income. If you do, come see me, we should talk. But if you don't, then it's very possible that this legislation won't have any impact on your future corporate tax rate.
With that being said, there's other reasons to consider potentially converting your C corporation to a different type of legal entity. I'm going to plug us again. All I can say is if you are considering doing this conversion, even though you know that this legislation will have no effect on your corporate tax rate, it's very important that you talk to a tax advisor, because converting to a C corporation to another type of legal entity could possibly trigger a taxable event. EisnerAmper, we have a deep bench of corporate tax experts. If you aren't already a client, feel free to reach out to me, or you can reach out to Mike if you like him better. Either of us can connect you with somebody to speak to about your specific questions.
Michael Morris:That's both domestic and international. Very good on that. All right. I've got another one here for you. You ready?
Daniel Krauss:No, I'm not ready. I'm not ready.
Daniel Krauss:Go for it.
Michael Morris:My family office is considering making an investment into a syndicated conservation easement. Interesting. Our investment advisor told us that we will receive a charitable deduction that will exceed our capital commitment by three times. Do you recommend this strategy for your clients?
Daniel Krauss:Well, first off I have to preface this by saying that I am not a wealth advisor and therefore I cannot give any sort of financial investment advice when it comes to any type of investment. I got to throw that out there. That being said, let's talk about what a conservation easement is, for anybody that is unfamiliar with this type of terminology. The original intent of Congress when they passed this regime was to give an income tax deduction to the owners of property who gave up certain rights of ownership to essentially preserve either the land and, or the buildings on said property for future generations. Mike, when tax strategies seem too good to be true, they normally are. As you would know, in 2017, the IRS issued a listing notice and in that notice, they made this type of transaction a listed transaction. The layman terms for listed transaction means a tax avoidance transaction. That's not good. You don't want to get involved in that, if you get the right advice.
Basically, this all came about because the folks that were promoting these types of investments, they were obtaining inflated appraisals on the actual easements once the land was donated. As a result of these inflated appraisals, that yielded a grossly overstated charitable deduction that was passed through to the partners of this type of investment. If you hear, "All you have to do is invest X and you're going to get three X on your investment," that's probably why.
Coincidentally, since somebody did ask this question, I just have to tell a brief story. I had a client that recently sent me correspondence from a partnership representative of an easement investment that they made over a decade ago. Client says, "I got this notice. What the heck is this? What do I need to do? I'm nervous." Well, after reading through the correspondence, the representative said that the partnership was under audit by the IRS, their entire charitable deduction has been disallowed by the IRS, because the IRS disagreed with the valuation that was used. More to follow. We plan on fighting this. We're going to take them to tax court. For all these reasons that I just mentioned, I typically advise my clients against this type of tax strategy, although, some clients don't listen and this happens to be one of them. I don't want to say, I told you so, but read in between the lines.
Michael Morris:We'll keep it anonymous. All right. Here's another one. My family office likes to keep things simple when it comes to our charitable endeavors. You have any other recommendations on a charitable giving technique that can give us more control over the timing and when the funds are dispersed?
Daniel Krauss:Basically, if you're not looking to take me up on my CLAT strategy idea, which I think is a great idea, but I'm not argue with this person. Some people do like to keep things simple and that's fine. I think the thing to consider is, if you don't already have it, you can set up what's called a donor advised fund, also known as a DAF. A DAF is a tax exempt charitable investment account that you could use to support your charitable organizations. The annual administration fees are extremely low. Since your DAF account isn't considered as separate legal entity, like a private foundation for instance, there's no separate annual tax filing requirement that you would have for setting up a DAF, which is a huge plus.
Just a couple of things to note. The donation once made it's irrevocable, but it enables you to take a charitable deduction on your tax return in the same year that you actually make the contributions. So you have more control over your money. The principal is going to grow. You could make recommendations to whoever the sponsor of your DAF is with respect to the public charities that you want to support, as well as the investment strategies that are being used to grow out the principles so that it will last longer, as opposed to just giving the money directly to a charity up front.
Michael Morris:Very good. Okay. We've got a few more questions here. Please send some through to our listeners if you want to ... Hopefully we'll get to them all. I see six more up there, but hopefully we'll get to them. All right. My office is considering setting up a charitable remainder annuity trust. Since this is a tax exempt entity, if we were to donate appreciated stock into the trust and then sell it, would the gain be taxed?
Daniel Krauss:Another interesting question. I'm going to shorten this up a little bit to get to some of these other questions, but basically a charitable remainder annuity trust, short for a CRAT is essentially the opposite approach of the CLAT strategy that we just spoke about earlier in our webinar. The logistics behind it is that you're going to have a trust set up, you're going to immediately donate cash, appreciated securities or other asset classes. The trust term that I've seen on a CRAT typically lasts for 20 years. During the trust term, the grantor or another recipient or recipients specified by the grantor will receive the fixed annual annuity payment, that could be as low as 5% or as high as 50% of the value of the total assets contributed to the CRAT over that 20 year term. If the trust sells the appreciated stock after it's already been contributed, the tax on the gain is going to be the responsibility of the annuity recipient.
Follow with me for a second. If you sell stock in the CRAT, the gain is a million bucks. The CRAT is a tax exempt entity, so there's going to be no tax levied by the CRAT. If all you have is this gain that you've now realized, and you have this 20 year annuity term, then all you're doing, assuming that the gain is higher than the annual annuity payments, is deferring the tax on the gain that eventually the recipient is going to recognize by the end of that 20 year annuity term. Just to clarify this a little bit, if you have $1 million gain and your fixed annuity payments are $100,000 on an annual basis, then you're going to have $100,000 in taxable income that's coming to you over a time horizon of that 20 year trust, assuming that there's no other income to consider. To wrap this up, you can defer it, but eventually you're going to be on the hook for the tax if the stock gets sold in the CRAT.
Michael Morris:All right. Here's another question from our audience. With the Senate proving nearly 80 billion in IRS funding, you anticipate increased scrutiny for S corporations broadly? That person will remain anonymous, who asked the question.
Daniel Krauss:Can we screen these questions for whether or not they're EisnerAmper employees or actual non EisnerAmper employees?
Michael Morris:I'm not familiar. We have so many colleagues, it's hard to keep track of everybody.
Daniel Krauss:I would say that I don't have a crystal ball. I can't tell you exactly whether or not that's true or not true. What I can say is there's clearly a reason why they've put so much money into funding. They've mentioned it in the notice that they want to fund enforcement. What does that mean? Well, we just spoke about syndicated conservation easements. What do you think is going to happen? They're going to have more bandwidth to target more of these partnerships that have this type of investment, because it's a listed transaction. Yeah. I think S corporations could be a part of that, but I think the list of transactions, like these easements, will definitely be a big part of the enforcement that will take place as a result of this funding.
Michael Morris:I read that in the Wall Street Journal just recently as well. I think there'll be a lot of scrutiny. I don't know specifically on S corps, but definitely the IRS is bulking up. Okay. Let's see here. I'm paging through a few here, so you'll have to bear with me. Let's see. Mitchell has a question. This is definitely one of our colleagues. We should mention something about the Roth 401(k)s. I'm assuming they have RMD requirements, interested to know why.
Daniel Krauss:I would say, specific to that question, reach out to me separately and we could talk about that. Send me an email. My contact information is posted and I will give you a response.
Michael Morris:Yeah. Okay. Well that's fair enough. We do have one more question, but it's I think a question asked when we were live. I don't have a relevance for it. I apologize we're not going to get to that. But we're actually nearing the end of the party here. I know this is recorded and it's super technical response. Please feel free to check into that. I'd be remiss if I really didn't talk about the extensive practices that we have for our family office clients, our 400 family office clients and then the network that we interact with. We have an entire not for profit practice that can help assist with setting up foundations or working with your not for profits. We can help advise with the not for profits that you're participating in. We have a whole cybersecurity group. Trust and estate group, many other experts in every area concerned with family offices. We can go deep.
Michael Morris:Dan, I want to thank you for an excellent job. You're a great friend and a colleague. Congratulations, again, on your partnership. I'm going to pass this over to our colleague. Thank you.
Daniel Krauss:Thanks, Mike.
Transcribed by Rev.com
Explore More Insights
Beneficial Ownership Information (BOI) Reporting Requirements Begin January 1, 2024Read More
Receive the latest business insights, analysis, and perspectives from EisnerAmper professionals.