Saving Taxes

Much has been written about the unbearable complexity of the Internal Revenue Code and its uneven and burdensome enforcement. As a practical matter, however, most of that analysis still leaves unanswered the question of how U.S. taxpayers should deal with this flawed system on a personal level. What should you do about your own taxes?

Since our practice is dedicated to helping families meet their long-term financial goals, our clients have faced this question thousands of times over the last two decades of turmoil in the U.S. tax law. As a result of this experience, our specific tax advice and planning ideas are based on a certain fundamental orientation. Here are our views on managing tax risk:
Tax Risk Can Be Minimized, But Not Avoided.   Given the complexity of the tax law today, and its inconsistent application by the IRS, it is impossible to reduce tax risk to zero.  The real question is how to manage tax risk: how to identify and quantify it, and how to reduce, tolerate and evaluate it.

Reducing Taxes is Critical to Financial Security.   Over the course of time, wealth is threatened by many risks - bad investment results, a rapidly changing economic environment, divorces and business litigation, spendthrift beneficiaries, expanding family needs, and most certain of all - taxes. Regular annual income taxes coupled with a wealth transfer tax on capital at each generation will substantially erode net financial returns, unless reduced by proper planning. Taxes are not always the determining factor in planning, but that does not mean that neglect is benign. Without tax planning, the real world tends to produce investment returns that are disappointing or even negative, when measured across more than one generation after taxes and inflation. Paying unnecessary taxes represents a loss of control.

Paying Gift Taxes Can Be a Good Investment.   Under the law now in effect in the U.S., very wealthy U.S. residents face an estate tax at death, but these “ death taxes ” can be reduced or avoided by making gifts. When substantial assets are involved, this may even involve paying gift taxes early. Under existing law paying gift taxes can be much less expensive in the long run than later paying estate taxes. Details Since paying gift taxes early may often be cheaper, this cost can be analyzed like any other investment opportunity. What is the expected return on the investment in paying gift taxes to save estate taxes? How does this compare with the risk-reward projected in other investment opportunities? We have, for example, seen instances in which estate taxes were reduced by millions of dollars by making a much, much smaller upfront investment in gift taxes and planning.

Even in the Face of Possible Future Estate Tax Changes.  The above analysis should consider the possibility that these taxes may be repealed, reduced or increased by Congress (or the states) in 2013 or later.  As a result of the new tax act in 2010, the federal estate tax is scheduled to increase in 2013.  However, as Congress faces tax reform and deficit reduction in the next two years, the possibilities multiply - - full repeal, higher rates only for very large asset values, and so forth. How can this uncertainty be taken into account in deciding whether to make gifts to save estate taxes in the future, when those taxes may be repealed or permanently reduced? The answer is to take that factor into account in the risk-benefit analysis. This can be done first by adjusting the gift plan to minimize the upfront cost of making the gift, and then by comparing that cost with the possible estate tax savings. In this way one can logically decide whether the cash-on-cash; investment “ return ” in saving taxes is high enough to justify the risk that the savings may not be achieved (because estate taxes would have been saved in any event to some degree). If this rate of return is high enough, then the decision to go ahead with gift planning can be warranted even in the face of the uncertainty of the result, just as with other investments. A rate of return on cash invested of say 10 to 20% per year, for example, cannot be found elsewhere without incurring the risk that it will not materialize. This analysis, combined with a consideration of the practical benefits of making gifts rather than passing property at death, should be considered whenever substantial assets are at risk.