Tax Planning & Magic Bullets

By Kenneth H. Bridges, CPA, PFS April 2021

Often when a prospective client calls me, it is because they have just gotten sticker shock after learning how much they owe with their tax return. Many times, it is because they have high W-2 income and received a significant bonus or stock compensation income during the year upon which their employer only withheld 22% Federal income tax (the required withholding on “supplemental income” below $1,000,000) rather than at their marginal Federal rate of 37%.  They feel that they must be missing out on something.  Frequently, my response is that I have no “magic bullets” to make the tax on W-2 income go away.

What we do is basic blocking and tackling, which is what we believe wins the long game, rather than trick plays and Hail Marys.  With that said, here, in no particular order, is a brief summary of some of the planning strategies we use; some of which perhaps do come close to being magic bullets.

IRC 1202 exclusion – This one is pretty close to a magic bullet.  If you invest in the stock of a qualifying C-corp and hold the stock for at least 5 years, then you can exclude from your taxable income gain on the sale of up to the greater of $10,000,000 or 10x your investment.

Deferral of capital gain into a QOF – If you reinvest capital gain (generally within 180 days of realizing the gain) into a Qualified Opportunity Fund (generally a partnership investing in a Qualified Opportunity Zone), then you can defer taxation of the gain until 2026, permanently avoid tax on up to 15% of the gain (depending on when you invested), and potentially permanently avoid tax on any appreciation in value of the investment (assuming held for at least 10 years).

IRC 1031 like-kind exchange – For a sale of real estate which is held for investment or used in a business, so long as you properly structure the transaction (e.g. use a qualified intermediary, identify potential replacement property(s) within 45 days, and close on replacement property within 180 days), you can defer the tax on a gain (potentially forever) by acquiring replacement real estate (which will also be held for investment or used in a business) of an equal or greater value.

Harvesting of capital losses – Capital losses can offset capital gains, but (other than a very limited amount) cannot offset other types of income.  Capital losses can be carried forward indefinitely, but cannot be carried back.  Accordingly, it is generally a prudent tax strategy to harvest capital losses whenever you can.

Exclusion for gain on sale of residence – Once upon a time, if you wanted to avoid paying tax on gain from the sale of your home you had to reinvest the proceeds in a home of equal or greater value.  The current rule (since 1998) is that you can exclude from taxable income up to $250,000 of gain ($500,000 for a married couple) on the sale of a home, so long as it has served as your primary residence for at least 2 of the immediately preceding 5 years.

401k, pension plan, traditional IRA and Roth IRA – Those with earned income (W-2 or self-employment income) can typically shelter from current tax some of that income (and potentially enjoy a lengthy or permanent deferral of tax on that income plus the future earnings thereon) by use of a 401k, pension plan, or traditional tax-deductible IRA. Those who believe they will likely be in a higher tax rate bracket in their retirement years than in the current year, may choose instead to make a contribution to a Roth IRA.  And even those who are not eligible to do a tax-deductible IRA or Roth IRA contribution (because of income level combined with participation in employer-sponsored plan) can often make nondeductible IRA contributions (which enjoy tax-deferred growth).  In addition to the income tax benefits, amounts in qualified retirement plan accounts generally enjoy creditor protection.

Conversion of IRA to Roth status – A year of low income when itemized deductions or standard deduction and low-rate brackets may be wasted is an ideal time to consider converting traditional IRAs to Roth status.  Also, a strategy of doing “backdoor” Roth contributions (nondeductible traditional IRA contribution followed by conversion to Roth status) can be effective for those who otherwise do not qualify for Roth contributions (but who do not have any zero or low basis traditional IRAs).

Planning around RMDs – Once you are age 72, you are required to take a certain minimum amount of distributions from your IRAs each year or otherwise face a draconian penalty. Deferring taking any distributions until you are age 72 is not always the best strategy, as there may be years between age 59 (the earliest at which you can generally take without penalty) and age 72 in which you can take some distributions at a lower tax rate than that which will apply once you begin your RMDs.  Also, for those who are philanthropic, distributions made directly to a charitable organization can satisfy the RMD requirement.

Charitable – Tax law encourages and rewards charitable giving, which can include cash donations (which generally provide a benefit equal to the donation multiplied by your combined Federal and state marginal rate), gifts of appreciated property (whereby you magnify the tax savings by also avoiding tax on the gain), gifts to a charitable remainder trust (which enable you to avoid incurring immediate tax on the sale of appreciated property and retain an income stream for life), gifts to a private foundation or donor advised fund (which provide an immediate income tax deduction to match the timing of a large amount of income while providing the donor many years to make transfers to charitable organizations), gifts of an IRA or from an IRA, and the granting of a conservation easement (although caution is in order here, as the IRS is heavily scrutinizing conservation easements based on perceived abuse in this area).

Relocation to a tax-friendly state – Most states subject their residents to tax on their worldwide income (while permitting them a credit or partial credit for tax properly paid to other states), whereas non-residents pay tax only on income sourced to the state (e.g. from business conducted in the state or real estate located in the state). State income tax rates on individuals can range from 0% to 13%.  Accordingly, substantial savings can often be generated from establishing domicile in a state with no state income tax (while minimizing contact to the extent possible with those states which have an individual income tax).

Become a resident of Puerto Rico – If you are a U.S. citizen or long-term resident of the U.S. then the U.S. tax system will follow you around the globe, with your worldwide income subject to U.S. tax; unless you renounce your U.S. citizenship and potentially (depending on level of income and net worth) incur an exit tax (tax on unrealized appreciation in assets). An exception to these general rules can apply if you become a bona fide resident of Puerto Rico.

State tax credits – There are various tax credits which can be utilized to minimize state income tax. Some must be generated by a business entity (e.g. the Georgia jobs credit, research credit and retraining credit), some can essentially be purchased (e.g. the Georgia low-income housing credit and film credit), and others are based on taking some action which the government is encouraging (e.g. the Georgia credits for donations to Student Scholarship Organizations, Innovation Fund Foundation, and rural hospitals). 

Federal tax credits – Similar to the state level (but generally not transferrable), Federal tax rules provide a plethora of tax credits for both businesses and individuals designed to encourage and reward behavior Congress has deemed desirable.

Children and education – While generally subject to limitation based on income level, the tax code provides deductions and credits associated with having children, paying for daycare, and education.  Section 529 plans (which are not subject to limitation based on income) permit investment gains to permanently escape tax, so long as the funds are used for qualified education expenses.

Positioning of investments – Investments which are likely to produce ordinary income and short-term capital gains (e.g. bonds, REITs and actively-traded mutual funds) should generally be in qualified retirement plan accounts, while investments likely to produce non-taxable income (e.g. muni bonds) or income taxed at favorable rates (e.g. growth stocks and index funds) should be in your taxable accounts.

Exercise of ISOs in year not in AMT – Incentive stock options” (ISOs) hold out the promise of being able to potentially convert what would otherwise be ordinary income into long-term capital gain. However, because the bargain element is an “alternative minimum tax” (AMT) adjustment on the date of exercise, the AMT often eliminates much of the hoped-for benefit. A tax year in which you will not be in the AMT represents an opportunity to exercise some ISOs at no tax cost, meaning a potential permanent tax savings if you hold the stock for the requisite period.

Sale of ISO shares that have fallen in value If you exercise ISOs and sell in the same tax year, then the AMT issue goes away.  Accordingly, we typically advise our clients who want to exercise and hold ISOs to do so early in the year, giving us almost a full year to watch the stock price and to sell the stock before year end if necessary in order to cure the AMT problem.

AMT credit for minimum tax paid in earlier years – Alternative minimum tax (AMT) which results from timing differences (e.g. depreciation and exercise of ISOs) can be carried forward and claimed as a tax credit in a year in which you are not in the AMT.

Deferral/acceleration strategies and rate arbitrage – In an era of very low short-term interest rates, we do not get too excited about short-term deferral strategies. Long-term deferral strategies like 1031 exchanges or the continuing year after year deferral from adoption of cash method are another story.  True permanent tax savings, however, tend to come when you can get rate arbitrage (e.g. take a deduction in a high marginal rate year and the related income in a low marginal rate year).

Installment sale method – Under the installment sale method, for sales of capital assets, you can generally defer tax until the year(s) of receipt of payment; or you can elect to report all of the gain in the year of sale if beneficial to do so.

IRC 469(c)(7) for real estate professionals – In general, passive activity losses can only be used to offset income from passive activities, and rental real estate is treated as passive. An exception is provided, however, for real estate professionals, who can generally opt out of these limitations with respect to the rental real estate in which they actively participate.

Estimated tax paymentsIn order to avoid a penalty, you are generally required to pay in through withholding or quarterly tax payments the lesser of 90% of your current year tax liability or 110% of your prior year tax liability.  With respect to estimated tax payments, you get credit the day you actually make the payment. Withholding, however, is generally deemed to have occurred ratably throughout the year.  Accordingly, if you realize late in the year that you have a shortfall for earlier quarters, you can sometimes avoid the penalty by increasing your withholding late in the year (e.g. having all of a year-end bonus withheld for taxes). 

Estate planning – Significant family wealth can be preserved by setting up family partnerships and trusts early and moving assets into them before they appreciate.

Choice of entity – One of the most significant decisions you face when starting a company is deciding through which type of legal entity you will operate the business; and for existing businesses, an evaluation should be made periodically as to whether the type of entity you are using is still the best choice for you.

Selection of accounting methodsNew businesses can, within certain limitations, select the tax accounting methods (e.g. cash or accrual) which are most beneficial for them; and existing businesses have some latitude to later change their accounting methods.  Your situation should be reviewed each year in order to determine which accounting methods are most advantageous for you; and a special rule (IRC 481) can permit you to spread over 4 tax years the recapture of the benefit you received from your prior method.

Optimizing the “qualified business income” deduction – The Tax Cuts and Jobs Act enacted in late 2017 included a special 20% deduction for most ordinary income from flow-through entities (e.g. S-corps and LLCs taxed as partnerships).  The deduction is generally limited to the lesser of 20% of K-1 income or 50% of the owner’s share of W-2 wages paid by the business.  The deduction can often be maximized by choice of entity and level of compensation paid to the owners.

S-corp and LLC basis and at-risk limitations In general, you can deduct your share of losses from S-corps and LLCs, and distributions from such entities are generally tax-free.  However, the ability to deduct losses or receive tax-free distributions is limited by the “basis” and “at-risk” rules.  Sometimes it is advantageous to make sure you have sufficient basis to deduct K-1 losses or avoid gain from distributions, and other times it is better to do the opposite.

Bonus first-year depreciation and Section 179 expense – The general rule is that fixed assets have to be capitalized and depreciated over time.  However, special rules can permit an immediate tax deduction for 100% of the cost.

Research tax credits – Federal and state rules designed to encourage and reward R&D can result in tax credits of up 18% of the amount expended (in addition to the deduction for the expenses). The credit can be utilized against income tax or, in some cases, enable a business to retain payroll taxes instead.

Employee stock ownership plan (ESOP) – For those who want to have broad-based employee participation in ownership of the company, an ESOP can be a very tax effective way to accomplish this; especially if the company is a C-corp (where the gain rollover provisions apply for a selling shareholder).

Get appointed to a U.S. Cabinet position – Persons appointed to a high-level government position (e.g. the U.S. Cabinet) who get a certificate of divestiture to avoid conflict of interest can elect to defer the gain from the sale of the asset into replacement property (IRC 1043). We haven’t actually done this one yet, but it seems like a great way to diversify your portfolio at no tax cost.

As I said at the outset of this article: no magic bullets, just blocking and tackling.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.