Saving taxes? Is that really ever the right objective?

A key financial objective of clients should be to find the most cost-effective and tax-efficient way to pay for expenses, from education to retirement, and to transfer assets to heirs.  Planning is not just about tax savings; it must be economically and financially beneficial, too.

For years, I have told our firm’s advisors, “The next person who comes to me saying that their client wants to save estate taxes will get a one-page (one-sentence) design:

“Given everything you own to charity when you die!”

The objective is not to save taxes.  It is really these two:

• The estate: “Maximize what I can leave my heirs.”

• Retirement: “Maximize my retirement income.”

Have you ever met a client who simply asked for ways to save current income taxes?  Of course you have.  But, how would they react to recommendations like:

• Pay your employees higher salaries.

• Increase benefits you provide your employees.

• Pay higher an interest rate on your debt.

• Pay higher legal, accounting, and financial planning fees.

All of these recommendations save taxes.  Do any of them provide a benefit to the business owner? 

Instead, tell the client, “If there’s a 401(k), that means that there’s also a 401(a, b, c, d, e, etc.)”  Review their current retirement plans.  There’s more to qualified plans than a 401(k).  When we do qualified plan analyses, we are looking to see how much can be allocated to the owners versus what they would net from simply paying taxes on their profits.

This above chart is an example of a “floor offset” defined benefit plan placed on top of an existing 401(k) plan.  The client had sufficient income to benefit from a $229,525 deduction. 

Eighty-five percent of the contribution was allocated to the owner, Mr. Brown.  If he was in a 40 percent combined federal and state income tax bracket, and he had not set aside these dollars into this plan, he would have netted $137,715.  Instead, $195,095 is working for him (tax deferred, more about that later).

So his choice is this:

How do you think he would rank the choices? I believe that the government needs the money.  I just want it funded by other people’s clients, not mine.

You should also review client’s non-deductible (after-tax) spending.  What is the most tax-efficient and cost effective way to pay for their children’s (and grandchildren’s) education, from private pre-school through graduate degrees? 

The key is finding lower tax bracket family members.  I have found more tax savings in a family tree than on a tax return.  Many of our clients have K-1 income reported on Form 1040, Schedule E, and/or other “business” income reported on their Form 1040, Schedule C.

With today’s high lifetime gift exemptions ($5.34M in 2014), you can gift income-producing assets (e.g., S-Corp stock, LLC member interests, etc.) to a trust designed to “spray” income to spouse, parents, children, siblings, etc.

So, how should I pay my daughter’s $60,000 school expenses?  In a 40 percent combined federal and state income tax bracket, I would need $100,000 to net $60,000.  But, my mother may need to receive only $80,000 to net the same $60,000 in her 25 percent combined federal and state income tax bracket.  My older daughter (after the kiddie tax age) may need to earn only $75,000 in her 20 percent combined federal and state income tax bracket.

Remember, direct gifts for education can exceed the annual gift exclusion ($14,000 in 2014). And even without that, they each have their own lifetime gift exemption ($5.34M in 2014).

That is much more tax-efficient that putting my mother or my daughter on the company payroll and paying FICA, FUTA, etc. After the education expenses are paid, the trustee can spray the income to my spouse.

For the business owner, you can also create a lower tax bracket enterprise (e.g., SLOB, separate line of business).  You establish a legitimate business reason to have a C-Corp.