A World of Taxes

The U.S. tax system is extremely complex, and to an investor it can be very dangerous–much like traversing a minefield without the proper maps to help navigate it. Whether he is a U.S. resident or not, the widening scope of U.S. taxation can cost the global investor prohibitively high rates of income and transfer taxes.

With good planning, however, the global investor with holdings in the U.S. may be able to legally minimize tax costs and therefore achieve a better rate of return, or get to keep most of the assets that he has accumulated through years of work and savvy investing. This article presents a portfolio of tax planning techniques that work. They cover a spectrum of situations. Each is only briefly sketched, and the advisor will need to customize them to individual situations.

Family Limited Partnership (FLP)

What it does: An FLP allows a family to own and control investments (which can consist of a variety of assets, such as cash, stocks, or real estate) in a partnership form (such as an LLC–Limited Liability Company–vehicle). Typically the parents retain control, but are able to transfer much of the equity value to their children at deep discounts for gift and estate tax valuation purposes, and therefore significantly slash potential gift and estate taxes.

It works because . . . when done correctly, U.S. taxpayers have been winning in court against the IRS, getting what is known as the “minority” or “lack of marketability” discount when it comes to valuing gifts of FLP interests.

It works especially well for . . . assets that are difficult to transfer or divide, such as real estate.

It can be used by . . . U.S. residents and non-resident aliens, known as NRAs.

Asset Basis Refreshing

What it does: Allows a non-resident alien to bring the tax cost basis of certain assets up to the fair market value level, and avoid future U.S. income taxes should the NRA acquire U.S. residency status in the year of sale of the asset.

It works because . . . for an NRA who is not yet subject to U.S. income taxation, he can generate a transaction that for U.S. tax purposes would recognize a basis step-up of the asset to fair market value, and yet for their home country tax purposes, the transaction is not taxed.

Examples include . . . sale of U.S. situs assets to an offshore entity; use of a U.S. check-the-box election for a foreign entity to receive stepped-up basis assets; use of an intentionally failed Section 351 transaction.

It’s particularly appropriate . . . as part of an NRA’s pre-immigration planning, or before an NRA comes to the States for an extensive period.

Can be used by . . . NRAs only.

Lifetime Gifts

What it does: Allows individuals to transfer assets to beneficiaries, efficiently utilizing their annual gift tax exemptions or a portion of their lifetime gift/estate exemption. Gets the future value appreciation of assets out of the estate, and cuts future estate taxes.

It works because . . . simple and well- timed gifts during life can work elegantly to reduce gift and estate taxes by using the annual gift tax exemption ($11,000 per donee in 2002). Combined with other techniques, such as the FLP above, this can be a powerful tool.

Examples include . . . We transferred real estate owned by a couple worth $2 million into an LLC. The couple has four adult children, all married, each with two children of their own. With each child’s household having four individuals, this means that each child’s family can receive $88,000 worth of gifts simply by using the couple’s annual gift tax exemption. Using a conservative 35% valuation discount on the LLC shares, an $88,000 gift to each child’s family reflects a $135,384 underlying real estate market value. In four years’ time, the couple can transfer substantially all the FLP’s equity to their four children’s families without touching their lifetime gift/estate tax exemption.

It’s particularly appropriate . . . for assets with future appreciation potential.

Can be used by . . . U.S. residents and NRAs (with some modifications).

Irrevocable Life Insurance Trust

What it does: Removes the life insurance proceeds from a person’s taxable estate, so the beneficiaries (spouse, children, etc.) get the insurance money free of estate or income taxes. A well-structured ILIT can also provide a way to “rescue” high-value assets in an Individual Retirement Account (IRA) that may get taxed at rates as high as 70% to 85% (estate and income tax rates combined).

It works because . . . by creating an irrevocable trust, a person can either transfer an insurance policy, or better yet, let the trust buy the insurance on her life. Since at the time of death, the trust owns the policy, none of the insurance proceeds are included in the taxable estate.

It’s particularly appropriate . . . as soon as a person–or a person and spouse’s–combined assets exceed the lifetime estate tax exemption amount. It may also never be too late. We recently arranged for life insurance on an 82-year-old who has substantial assets in an IRA account, reducing a significant amount of future estate taxes.

Use of Non-U.S. Entity

What it does: Allows a non-resident alien to avoid U.S. estate taxes on U.S. situs property.