Future Planning: Tax Strategies for Family Offices

MM:What are some trends that you're seeing with your family office clients?
DK:I would say the top two issues right now would be my clients are concerned about looming tax reform from the Biden Administration based off of their efforts in trying to have sweeping tax reform that really target high net worth clients. The second part being is really an increased focus on succession planning for the next generation in response to the Biden Administration's efforts on tax reform.
MM:Based on the trends that you've just described, what are some tax strategies that you've been using with your family office clients in response to tax reform concerns?
DK:So I would say, at the moment, based off the fact that tax rates are trending to go up in the future, we just don't know when, and at this point it could be as early as 2023, a lot of our clients are giving serious consideration to locking in more favorable federal long term capital gains rates, which are currently at 20% right now, to liquidate some heavily concentrated stock positions, and I work hand in hand with their financial advisors to run through strategies, to just really understand what the tax ramifications would be based off of selling today at a 20% versus selling at a later date, when this favorable tax rate can go away, and you could be looking at getting taxed at ordinary rates, which as of today are as high as 37%.
MM:Well, I think that's all very interesting. Tell us a little bit about the Roth IRA conversions.
DK:So based off of where things stand today with the stock market, a lot of people are seeing their account balances shrink substantially based off of the economic conditions that everybody is currently facing. So now is a really good time to consider a strategy in which you take your retirement account balance, which is tax deferred in, for instance, a traditional IRA. And what you can do is you can convert that account balance all, or a portion, it's up to you, to what's called a Roth IRA.

And by doing this, you are locking in today's value as of the conversion date. So for example, if your account balance is down to a million dollars, and you want to convert that entire balance, a million dollars would be included in your taxable income. Once the conversion happens, it's irreversible. You can't go back. However, some of the upside here, outside of obviously locking in lower value, would be you no longer have a required minimum distribution, a requirement upon retirement age. And therefore, if you are a high net worth individual and you don't think you're ever going to have to use your retirement account in order to cover your living expenses, that this is something that can get passed to the next generation without you having to take distributions from it. And lastly, I think the biggest upside is that you're locking in today's tax rate. And when the money eventually does get distributed to your heir, as far as the account beneficiary, the principle that went into the account and any future appreciation would be tax free.
MM:Okay. Since 2018, a large contingent of attendees today that live in high income states, that would include you and I, have been limited to a tax deduction of 10,000 on their federal income tax returns, with respect to state income taxes and property taxes. Dan, tell us what planning have you done with your clients to make up for this lost tax benefit?
DK:So, Mike, at this point, nearly half the states with state income tax have enacted an elective passed through entity tax to help individuals recoup that lost federal tax benefit that you just mentioned, which results in a $10,000 cap on the deduction that they can take on their federal return for state and local taxes. This PTE regime is enacted specifically for a pass through entity, which for the most part could be either a partnership, or an S corporation, to make an election on behalf of their owners to pay an entity level tax. The income taxes that end up getting paid by the pass through entity are fully deductible for federal tax purposes against the income that gets allocated to the owners of that pass through entity. And at the state level, the owners will be able to either claim a credit for the taxes that were paid on their behalf against their individual income tax liability, or in some instances, the income from that pass through entity could be excluded from other tax bill for state income tax purposes.
MM:All right, well, that was pretty technical, and I can see why we've got to pay to get the professional services that you're offering. Does California offer this PTE tax benefit to tax payers that are subject to California personal income tax?
DK:They sure do, Mike. The bill was first enacted in July of 2021. However, there were two major flaws with the bill, the first being, they limited the number of entities that were eligible to actually make this election. And number two, they imposed a floor on how much credit could be used to actually reduce an individual state income tax liability on an annual basis. And so that created doubt as to whether or not the credit could actually be fully utilized by the electing taxpayer, and therefore a lot of tax practitioners were not happy about the original bill, and eventually the FTB listened to our complaints. This legislation was amended to fix both of these issues in February of 2022, which resulted in a major windfall for taxpayers that are subject to California personal income tax. And this legislation was made effective for tax years, beginning on January 1st of 2021, by making this election, owners are subject to an entity level tax of 9.3% on their distributive share of both income and guaranteed payments that they receive that are subject to California personal income tax.

Just to provide a brief example of how this would work, if you have a million dollars of taxable income from an electing pass through entity that is subject to California personal income tax, the payment that would need to be made on your behalf would be $93,000. If your effective federal tax rate is 37%, that means that you would receive the federal tax benefit for that payment of $35,000 and thereby completely avoiding the $10,000 cap that you would ordinarily be subject to on your federal return for state and local income taxes that get deducted.
MM:Dan, that's super interesting. What considerations should be made before making a PTE election?
DK:So if you're the owner of a multi-state business and you're considering making this election outside of your home state, you're going to want to confirm that your resident state allows you to claim a credit for PTE taxes that you'd be paying to that other state. Additionally, if there are owners in the business that you'd be considering making this election from, and they don't want to participate in this election, there are some states that require unanimous consent amongst all the owners and there are states that don't require every owner to participate, so it's important to understand what the rules are in the state which you're considering this election. So my advice would be to consult with your tax advisor to just understand the nuances between all the states that you would consider making this election in.
MM:You mentioned earlier that you've seen an increased focus on family succession planning. Our family's going through the same exact thing right now. What role have you played in this process, from a tax advisor perspective?
DK:Most of the clients that I currently work with have done quite a bit of wealth transfers throughout their lifetime when the lifetime exemption amount was five million dollars over a decade ago, and they haven't really done a lot of planning since then. Starting in 2018, the exemption amount for wealth transfers increased to over 11 million dollars per taxpayer. And in the current year, that magic number is approximately 12.1 million dollars, with the possibility that the lifetime exemption might drop back down to five million dollars, many of my clients with taxable estates, or at least are revisiting the idea of additional wealth transfers before it's too late.
MM:What wealth transfer techniques have you seen in the marketplace lately?
DK:Several of the clients that I work with already have family limited partnerships in place that are really made up of just publicly traded securities and alternative investments in both private equity and hedge funds. These clients are now rushing to give a larger percentage of their limited partnership interest to their heirs, due to the fact that the market is down and there are valuation discounts to be had. So while I'm sure most people that might be listening to this podcast are probably avoiding looking at the value of the portfolio balances in their partnerships, there's at least a silver lining on the trust and estate planning side.
MM:So to extend this question a little bit more, Dan, are you working with wealth advisors and trust in estate attorneys to help your clients?
DK:100%. It's a collaborative effort, and it's important that everybody's on the same page when considering a strategy like this.
MM:Well, I know you're a team player and you do a great job at that. 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?
DK:That's an excellent question, Mike. The one strategy we've been taking a close look at would be the creation of a trust known as a Charitable Lead Annuity Trust. While it's a little bit technical for this podcast, the main points are as follows. The granter is going to set up a trust. They're going to name a charitable beneficiary, and the trust is going to only last for a certain timeframe, which in my experience has been between 10 to 15 years.

The granter is going to contribute assets inside the trust, which could be combination of cash, or marketable securities, and the trust is going to make payments to the charitable beneficiary that are just fixed payments over the 10 to 15 year period. Once the 10 to 15 year period is elapsed, any assets remaining in the trust can get passed to the grantor's heirs without any gift tax consequences as long as certain criteria are met, and the upside for the granter outside of not paying gift taxes would be that when the assets go into the trust, let's say we take a million dollars of cash, that million dollars will be an immediate income tax charitable deduction on their federal return.
MM:Thank you Dan Crouse for your excellent overview, and thank you to all our guests for joining our session. If you've got any questions, please don't hesitate to reach out.

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