Tax planning is an indoor sport usually only played by adults. This particular tax game is for the young. Most players are about 40 years old or younger. The younger the better. Actually, we train our clients to call when the baby is born.
The name of the game is private retirement plan. A prp is similar to a Roth ira, which in general allows you to put $2,000 (or $4,000 if you are married) into an ira every year. Although you don’t get a deduction, every dollar you take out after five years (as long as you are older than 591/2) comes out tax-free.
But sorry, you cannot play the Roth ira game if you have no earned income (like almost every little kid) or you earn too much money (like most of the people who read this column).
Instead, you can play the prp game, where the amount of your earned income doesn’t count. And you can put as much money as you want into the game — or maybe a grandparent will put it in for you — every year. Exactly how the prp game is played is best shown by real-life examples. The following two cases — taken out of our private consulting files — will show you how and why others have started a prp.
The first plan is for baby Jordan, an 8-year-old who obviously had no earned income. The second plan is for Jordan’s dad, Sam, a 34-year-old, who earns $170,000 per year (helping his dad, Joe, run a successful family business).
Jordan’s prp. The annual contributions (actually insurance premiums) to the prp are gifts from Grandpa Joe. Joe will make a gift (during Joe’s life or at his death in his will) of $4,000 per year to the prp for 42 years (Jordan will be 50 years old) or a total of $186,000.
Starting at age 66 Jordan will receive $380,708 for life. Appropriate trusts would provide for the details needed to implement the plan. The total benefits ($380,708 each year, plus death benefits) increase the longer Jordan lives. For example, if Jordan lives to age 80, the total benefits to him and his heirs would be $10,362,169. Wow! Sure beats the old $10,000 or $20,000 annual gift idea.
Sam’s prp. Sam waived out of the family business 401(k) plan and is providing the annual premiums for his own prp. Sam decides on a plan to contribute $20,000 for 21 years (a total of $420,000) with contributions to stop at age 55. Note that the amount of the annual contributions and the number of years to be paid are tailored to accomplish the specific results desired.
Sam will receive a retirement benefit of $165,664 starting at age 65. Joe’s total benefits rise from $2,616,536 at age 65 to $5,255,342 at age 85. All from a total contribution of only $420,000. What’s the secret behind the huge dollar results? Simply put, the large numbers grow because a prp allows money to be compounded over time in a tax-fee environment.
Just a note: if everything in Jordan’s plan were identical, except Jordan is a 1-year-old instead of an 8-year-old, the annual retirement figure would be $611,620. Really, an easy way to create future millionaires.
As you can tell by the numbers, youth is rewarded by a prp. And oh, yes, all the retirement figures and death benefits would be 10% higher for females because they have a longer life expectancy.
Retire, but don’t sell
This war story is true. A reader of our column, let’s call him Joe, recently called me with a typical request: “Irv, I want to retire. Will you value my business so I know how much to sell it for?” After a short conversation, two important parts of Joe’s business and financial picture came into clear focus: 1) Joe’s business was valuable and would be easy to sell, but 2) the tax cost would be murder. Unfortunately, many readers — like Joe — are in the same boat. They just don’t know it.
An in-depth consultation a few weeks later completed the puzzle. Joe, age 62, has three kids — a son and daughter in the business and a son who is not interested in the business. Joe owns all the stock of Success Co., a C corporation (a tax-paying corporation).
Success Co. owns appreciated assets — land, buildings and good will — that are worth about five times their book value on the company’s books. Good will, as is usually the case, is not on the books or, put it another way, is on the books for zero.
Joe started the business 28 years ago with $4,000 of his own money and a large loan — paid back long ago —from his dad. To keep it simple, let’s say Joe’s tax basis for the Success Co. stock is zero.
Now the economic facts and the tax problem. The business, including the appreciated assets, is worth $2.5 million. Great! The tax hit to the corporation if it sold its assets would be about $600,000. What happens when Joe takes the $1.9 million balance out of the corporation? Another tax hit. This time about $380,000.
True enough, the $1.52 million left is a nice bundle of cash but not nearly enough for the after-tax investment income (estimated at $60,000 to $80,000 per year depending on interest rates) to maintain the retirement lifestyle Joe and his wife have dreamed about. For Joe to pay almost half the business’s value in taxes to accomplish his retirement goal is insanity. What to do?
Don’t sell the business. Keep it. Without covering every detail, here’s the basic plan we worked out for Joe:
Success Co. elected S corporation status. Joe retired. The kids run the business anyway. Yes, Joe consults — working half days — about six to 10 times a month, except in winter when he goes south. Success Co. usually makes $300,000 to $450,000 per year before any salary or fringe benefits to Joe. That leaves plenty of room for Joe to take $100,000 after taxes (more or less) of S corporation dividends (plus a small salary and his usual fringe benefits) to fund his annual retirement needs.
We also put two additional plans into effect: first, a transfer of stock plan to the children including a buy-sell agreement; and second, an estate plan for Joe and his wife, funded by insurance, that will eliminate all gift and estate taxes.
Donate excess inventory
Your company’s excess, slow-selling inventory can become a tax-advantaged deduction when you donate it to a qualified charity. This type of philanthropy is called gifts-in-kind and favors companies that contribute new, unused products.
Regular C corporations may deduct the cost of the inventory donated, plus half the difference between cost and fair market value (your selling price). Your deduction may be up to twice your cost. S corporations, partnerships and sole proprietorships earn a straight cost deduction (see section 170(e)(3) of the U.S. Internal Revenue Code).
For example, you sell a product for $2 that cost you $1. Your deduction for donating that product would be $1.50 (cost plus half the difference between cost and selling price).
For companies that do not need the cash right away, donating improves the bottom line more than liquidating stagnant inventory. And, in most cases, it lets your business clear its entire excess inventory at once, instead of negotiating with liquidators who may pick and choose.
Check your storeroom or warehouse. You’ll save space and insurance costs and increase your cash flow with a terrific tax break.
The best way for most businesses to take advantage of an inventory charitable deduction is to use the free service of a “charity middleman,” such as the nonprofit National Association for the Exchange of Industrial Resources. The organization accepts product donations, provides you with proper tax documentation within 14 days after receiving your inventory, and then redistributes the goods among 6,000 qualified schools and charities across the United States.
The donation process is simple. Naeir asks you (the donor) to submit a written proposal that includes a short description of the inventory, quantities, and a wholesale or cost value.
Naeir’s Donation Review Committee then approves the proposal and sends you a confirmation letter, labels and shipping instructions. While donors are responsible for shipping costs from their facility to naeir’s warehouse in Galesburg, Ill., or Porterville, Calif., that cost increases your deductible donation.
Naeir will not charge your company for its services. Since 1977, U.S. corporations have donated more than $1 billion worth of inventory using this nonprofit program.
Naeir’s 450,000 sq. ft. warehouse allows it to accept any size donation, from a single box to dozens of semi-trailerloads.
For naeir’s free, no-obligation donation guide, call 800/562-0955.