“Basing investment decisions on forecasted tax changes is about as surefire a strategy as asking the Ouija board for stock tips. But whether the Bush tax cuts are allowed to expire on schedule or a compromise is found, it’s all but certain that tax hikes included in the health-care-reform law will start affecting high earners on Jan. 1.
The law imposes a 0.9% surtax on wages and other earned income for individuals who make more than $200,000 and couples earning more than $250,000. But the bigger hit for those taxpayers comes from a new 3.8% levy on investment income, including capital gains, dividends, and carried interest. Here are four strategies for softening the blow:
Sell Assets. Taxes shouldn’t be the only force driving a sale, and some aspects of life are beyond our control, but business owners serious about selling their company should try to get a deal closed this year to pre-empt the hit. “You’d want to close a sale in December, rather than in January,” says Carol Kroch, head of wealth and financial planning at Wilmington Trust.
Similarly, investors already planning to unload a large single-stock position in the next five years, to diversify or free up cash, for example, may want to move up sales to this year.
Attorney Martin Kalb has one client who is sitting on a $250 million single-stock position, as a result of selling his closely held business in a stock-for-stock transaction 12 years ago. The investor has never paid any taxes on the shares and has a near-zero cost
basis, says Kalb, Miami-based co-chair of the global tax group for Greenberg Traurig. “If he sells $100 million of the stock, he’d be saving $3.8 million in taxes by doing it this year,” he says. That difference will be even bigger if the Bush tax cuts expire as scheduled, in which case the top rate on long-term capital gains will rise to 23.8%, including the new surtax, from 15%.
Although profits from real-estate sales are generally subject to the surtax, don’t rush to throw Tara on the market — couples are allowed as before a $500,000 exemption on gains realized from selling a primary residence, and single filers get a pass on the first $250,000 of profits.
Distribute Dividends. Owners of closely held businesses and partners of private-equity funds can accelerate income into 2012 by drawing special dividends from their companies before the end of the year. Firms that have the funds readily available can pay with cash on hand. For private-equity managers, low interest rates enhance the appeal of using low-cost loans to finance special dividends from subsidiary companies.
Small-business owners can also issue dividends in 2012 in order to reduce the value of their companies in anticipation of a sale. Daniel Zucker, a tax attorney with McDermott Will & Emery LLP, is working with one family on the sale of its equipment-manufacturing business. The family has a buyer lined up and is hoping to complete a deal this year, but regulatory hurdles threaten to drag the sale into 2013.
If that happens, the business will pay a special dividend to the family before the end of the year, in the form of promissory notes. The buyer will pay them off as part of the transaction in 2013, meaning the notes should dollar-for-dollar reduce the selling price of the company. Family members will pay dividend taxes on the proceeds in their 2012 returns.
Buy an Insurance Wrapper. Private-placement life insurance offers appealing tax benefits, plus the chance to shelter relatively large sums of excess cash. The policies usually require at least $1 million in premiums, although they’re more commonly sold with premiums of $5 million to $20 million. The appeal lies in the tax-free growth of the policies’ cash values plus the opportunity to invest those balances in hedge funds, which are often tax-inefficient but can’t be purchased in traditional insurance policies. Although advisors say investors ought to buy the policies with money they don’t anticipate needing in their lifetimes, if structured properly, private placement life insurance allows-for tax-free withdrawals up to the amount of premiums paid. After that, policyholders can generally take a low-cost loan against the amount of any growth in the cash value.
One drawback is that buyers must relinquish a certain amount of control with the money they invest. Insurance providers can’t offer every hedge fund under the sun, and although policyholders can retain control of allocating their cash value among different funds, they’re prohibited from investing it in any funds they themselves manage. Says Edward Renn, a partner with Withers Bergman LLP: “You can invest with the second-best manager in the universe, but you can’t invest with yourself.”
Convert an IRA. One easy way to help manage the tax is an old standby: Convert a regular individual retirement account to a Roth IRA. In such cases, savers pay ordinary income taxes on any amounts they convert, after which funds can grow and eventually be withdrawn tax-free.
Pretty sweet, particularly since distributions from both types of retirement accounts are exempt from the new taxes. But unlike payouts from a regular IRA, distributions from a Roth don’t get factored towards filers’ modified adjusted gross income, which determines exposure to the tax. That means a conversion could help taxpayers at some future date, reduce their liability or skip the surtaxes altogether, once they start taking withdrawals.”