By Robert Pagliarini,
Tribune Media Services
The money you receive from sudden wealth — whether through a lawsuit settlement, business sale, entertainment or sports contract, or stock options — can suddenly be gone if you don’t manage federal and state income taxes. For example, let’s consider a $20 million lawsuit settlement. After 40 percent is paid to the attorney and up to 54 percent is paid in federal and state taxes, you may be left with closer to $5 million. While that’s still a windfall, you may be able to keep more by engaging in one or more of the following windfall income tax planning ideas:
1. Create a pension. Don’t be discouraged by the paltry IRA or 401(k) contribution limits. A defined-benefit pension can give you the opportunity to shield an incredible amount of money from immediate taxation. How much? A married 45-year-old may be able to shelter up to $320,000, while a married 55-year old may be able to shelter up to $530,000. This technique works best when you can contribute over multiple years, so if possible, splitting your windfall over the course of two years is ideal. This will allow you to contribute the maximum to the pension this year and next. Using a pension to minimize taxes only works if the windfall is earned income — sorry lottery winners.
2. Create a captive insurance company. This is an advanced strategy that requires having the right tax and legal team, but the rewards can be worth the cost. The IRS allows you to deduct up to $1.2 million if done correctly. According to Los Angeles tax attorney Bruce Givner, “a captive insurance company is an attractive structure that can provide a terrific result in terms of risk management, estate and gift tax planning, asset protection planning, and income tax planning.”
3. Use a charitable limited liability company. By using a charitable limited liability company, you may get a deduction of approximately 85 percent of what you contribute. Of course, this only works if you have an interest in giving and have a favorite charity you would like to support. How does it work? Says Givner, “This is a strategy where the client ends up with an LLC that is full of money that can be used for investment — including loans for business opportunities — and the charity receives a steady stream of revenue for its membership interest.”
4. Use a charitable lead annuity trust (CLAT). Structured properly, a CLAT can create a large income tax deduction. But what’s a CLAT? They have been around since the 1970s and the mega-rich such as Jacqueline Kennedy Onassis have used them. Basically, you contribute money into a trust and determine a certain amount that will be withdrawn and sent to a charity while the remainder assets come back to you after a certain time period — the longer the time period, the larger the deduction. For example a 20-year term may provide you with nearly a 90 percent deduction while a 10-year term will provide a 47 percent deduction. This is a strategy Givner recommends because “the client gets a large upfront deduction and then, at the end of 10 or 20 years, gets all of the assets back, probably at a time when the client will appreciate them even more.”
5. Take advantage of tax benefits to farmers. U.S. and state governments provide all kinds of tax breaks for real estate investments involving agriculture such as avocados, grapes, pistachios and honeybees. And you’ll join the ranks of celebrities such as Jon Bon Jovi, Bruce Springsteen and Ted Turner who have capitalized on heavy tax benefits provided by Congress to farmers.
6. Buy commercial property. Depreciation is a double-edged sword. When you drive a new car off the lot and you instantly lose 20 percent of its value, depreciation is not your friend, but you can have depreciation work for you. Here’s how: Buy a commercial or industrial building and use component depreciation (also called cost-segregation accounting). According to Givner, “depending upon the building, you may be able to depreciate up to 40 percent of the value of the building within the first five years.”
A windfall is only as much as you get to keep. While you won’t be able to avoid all income tax on your sudden wealth, there are many advanced strategies such as those above and others you can use to minimize the income tax you have to pay. Get the right tax, legal and financial team together to analyze your options.
Robert Pagliarini is a CBS MoneyWatch columnist and the author of “The Other 8 Hours: Maximize Your Free Time to Create New Wealth & Purpose” and the national best-seller “The Six Day Financial Makeover.” Visit YourOther8Hours.com.
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This was printed in the March 9, 2014 – March 22, 2014 edition