Pure Imagination

Fifty years ago on June 30, Paramount Pictures released an enchanting spun-sugar delight of a movie that remains a classic. Willie Wonka and the Chocolate Factory features Gene Wilder as the reclusive confectioner who hides five Golden Tickets in his candy bars and promises the finders a tour of his mysterious factory and a lifetime supply of chocolate. It's a magic ride down a river of chocolate, set to music that snagged an Oscar nomination for Best Original Score .

They say there's a fine line between genius and insanity. I think we can all agree that Wonka just obliterates it. It takes a genius to stock a candy store with the likes of Squelchy Snorters, Gelatin Frogs, and Scrumpdiddlyumtious bars. But only a madman could look at that ouevre and think, "no, what I really need is some three-course-meal gum, fizzy lifting drink, and flavored wallpaper you can lick." (The snozzberries taste like snozzberries!)

Sadly, though, Wonka's genius doesn't translate to tax planning. As the glass Wonkavator screams into the sky, carrying Wonka, Charlie Bucket, and Grandpa Joe high above the town, Wonka explains that he staged the entire contest to find someone worthy enough to take over the factory when he retires. (It's scary to think what a guy like Wonka could do in retirement when he has even more time to putter around in the kitchen.) Lucky Charlie doesn't just win a lifetime supply of chocolate — he wins the factory that makes it!

Here's the problem. It has to do with something called "basis," and it's boring to explain. We all know that when you give someone a gift, it's gauche for them to sell it. But if they do, when it comes time to pay tax on their gain, they don't get to start with what it was worth when you gave it to them. They have to use something called "carryover basis" — the amount you would have used if you had sold it. Now, you can say it serves them right for selling your gift. And you'd be right! But it still means paying more.

However, if Wonka waits to bequeath the factory to Charlie at his death, Charlie gets something called "stepped-up basis." That means if he sells, his basis is the factory's fair-market value as of the date of Wonka's death. That lets Charlie avoid tax on the gains during Wonka's lifetime entirely!

Let's not forget transfer tax considerations. If Wonka gives the factory to Charlie, there's gift tax due now — but he avoids transfer tax on future appreciation. If he bequeaths it, there's an estate tax payable. Wonka appears young and healthy — Wilder was just 37 when he filmed the part — so maybe an irrevocable life insurance trust makes sense. (The Princess Bride's Dread Pirate Roberts solved a similar problem by creating what was essentially a "dynasty trust" for his title.)

The movie leaves a couple of other important questions unanswered. We know that Wonka paid the Oompa-Loompas with cocoa beans. What are the Section 83(b) consequences of fluctuating commodity prices? And what demented Hollywood producer woke up one morning in 2005 thinking, "Lets remake the whole thing, but with Johnny Depp as a really creepy Wonka"?

At this point, you may be wondering why we're spoiling childhood memories with boring tax talk. (At least we're not fat-shaming Augustus Gloop.) But there's a real lesson here. Someday you might want to sell your chocolate factory, too, whether you inherited it, won it, or built it with your own two hands. When that day comes, we've got all sorts of tasty recipes for keeping your gains away from the Slugworths at the IRS!

Eat the Rich

Most Americans would agree that capitalism is the greatest wealth creation engine the world has ever known. But it's hard to argue that capitalism distributes its rewards equally, and today's "winner take all" economy is concentrating wealth beyond Gilded Age levels. Forget about that top 1% the "Occupy Wall Street" movement targeted; we're talking the 1% of the 1%. That drives the central question of today's political economy: how hard should government work to combat inequality? People can and do argue in good faith from "not at all" to "lots harder than we are now."

Last week, the non-profit newsroom ProPublica cannonballed into that debate with a mighty splash — a report called The Secret IRS Files." Someone risked serious jail time to leak 15 years' worth of tax returns from bold-face names like Jeff Bezos, Elon Musk, and Warren Buffett. "IRS records show that the wealthiest can — perfectly legally — pay income taxes that are only a tiny fraction of the hundreds of millions, if not billions, their fortunes grow each year."

Pretty bold, and pretty damning, right? ProPublica continues, "America's billionaires avail themselves of tax avoidance strategies beyond the reach of ordinary people . . . . We compared how much in taxes the 25 richest Americans paid each year to how much Forbes estimated their wealth grew in that same time period. We're going to call this their true tax rate." But anyone who's taken a class in Federal Income Taxation can spot the flaw here — as the report itself acknowledges, those gains don't count as income "unless and until the billionaires sell."

What sort of numbers are we talking about? From 2004-2018, Warren Buffett's wealth grew by $24.3 billion. Yet over the same period, he paid just $23.7 million in federal income tax, for what ProPublica calls a "true" tax rate of just 0.10%. Scandalous, right? Storm the castle with torches and pitchforks! Well, no. Over that same period, Buffett reported $125 million of "income" under the statutory definition. So the $23.7 million he paid represents a far-less-scandalous 18.96%.

So, billionaires like Musk watch their stock soar and borrow against it to spend tax-free loan proceeds instead of selling it to spend taxable income. And the fabric in his socks is probably finer than the suits most men are buried in. But that strategy isn't limited to billionaires. If you bought a house 10 or 20 years ago, you've probably seen its value double or triple. You haven't paid any tax on that gain either. And you can borrow against it, just like Musk, with a home equity loan. Use the proceeds for business or investment and you can even deduct the interest you pay!

Oh, and when it comes time to sell that house? You'll get to exclude up to $500,000 of gain from your income. Elon Musk paid $17 million for a Bel-Air house in 2013, then sold it last June for $29 million. He'll pay a much bigger percentage of his gain in tax than you will.

We're not here to defend the tax system. But like it or not, it's the only one we've got. And as Judge Learned Hand famously said, "anyone may so arrange his affairs that his taxes shall be as low as possible . . . there is not even a patriotic duty to increase one's taxes." (With a name like Learned Hand, he would know.) So count on us to help you pay less. ProPublica says it's perfectly legal . . . and Learned Hand says it's ethical and moral, too!

Rope, Shoot, Fry, Tax

Taxes were in the news this Memorial Day weekend: the new administration leaked word that the higher capital gains taxes included in their American Families Plan would be retroactive to April when they first rolled out the bill. That's drawn predictable fire from the usual suspects on Team Red and the editorial staff at the Wall Street Journal.

Raising that rate from 20% to 39.6% is obviously a big deal. But even if it happens, it would only affect gains on sales for taxpayers making over $1 million in a single year. That's pretty elite company — just three out of every thousand Americans report earning that much. And those folks are concentrated in a handful of high-income, high-tax states, including 72,470 in California and 50,800 in New York. Alaska and West Virginia managed to scare up just 710 million-dollar earners each.

 But what if we told you taxing the rich isn't where the real action is? What if we told you the tax man was like a sleight-of-hand artist, distracting your eye with a flash of his right hand while he hides a rabbit in his hat with his left?

Everyone knows that taxes are higher in California than in Texas, right? California's top income tax rate is 13.3%, while Texas charges (*checks notes*) nothing. That's why half of California has moved to the Lone Star state in the last couple of years. Your mortgage dollar goes hella farther in Austin than it did in Tiburon, too. (Californians looking to make Caitlyn Jenner the next Governor might want to check if U-Haul is paying kickbacks to Gavin Newsom.)

But for middle class earners, taxes are actually higher in Texas. How can that be? Texas raises most of its revenue from property and sales taxes, which hit upper-income earners less. Texas's average property tax rate is more than double California's. And California's income tax includes a generous refundable Earned Income Tax Credit for working families that wipes out a lot of the property and sales taxes they pay.

For those reasons, the Washington-based Institute on Taxation and Economic Policy ranks Texas #2 in their "Terrible 10" most regressive state tax systems. (Don't look so smug, Washington, you're #1!) California ranks most equitable. Of course, the Golden State also serves residents an all-you-can-eat buffet of wildfires, earthquakes, floods, and mudslides. Life is full of trade-offs.

You may be wondering how lowly sales taxes can make such a big difference between states. But they add up fast. When was the last time you paid attention to the "sales tax" line on a register receipt? (If you're shopping at CVS, you probably can't even find it.) You can probably remember a time when online retailers like Amazon didn't charge sales tax. But the Supreme Court's 2018 Wayfair decision holding that states can charge sales taxes on out-of-state sellers, even with no in-state physical presence, opened the floodgates to new revenue.

As for that proposal to nearly double taxes on capital gains, many observers have already pronounced it DOA — retroactive or not. The smart money says it may land somewhere in the neighborhood of 25%. That's where we come in. We have a whole suite of strategies to minimize, defer, or even eliminate taxes when you sell your business, real estate, or other big-ticket assets. So call us regardless of where you're planning to move, and we'll help you take more with you!

And Baby Makes Five

In 1979, China launched what would become the world's toughest population control measure, the "one-child policy." Families with just one child got rewarded with a "one-child glory certificate" and five yuan per month (about as exciting as a stack of Wendy's coupons). There were always exceptions: in most areas, you could apply for a second child if your first was a daughter. However, as China's people grew older and more affluent, the government raised the limit to two children to stave off economic risks from the aging populace.

Last month, still dismayed by a fertility rate of just 1.3 children per woman, China raised the limit to three kids per family. But just giving parents permission to have more isn't enough. Kids are expensive, in China just like they are here. (They're sticky, too.) So the government also rolled out a package of financial incentives, including tax and housing support and limits on "sky-high" dowries. The government also plans to educate young people "on marriage and love," which sounds about as hot and sexy as . . . you know what, let's just not go there.

Naturally, that got us thinking about the role that taxes play in family planning. The USDA estimates that the average "affluent" family (earning over $107,000) spends $372,210 to raise a child from birth to age 17. That's before college, grad school, and maybe a wedding (but fortunately not a dowry). While our tax code offers up a few specific goodies for parents, they don't add up to $372,210. But let's take a look at how our tax code does help families carry that load.

Here in the United States, the Tax Cuts and Jobs Act of 2017 eliminated the personal exemptions we used to take for granted. At the same time, it doubled standard deductions, lowered overall rates, and boosted the Child Tax Credit. Most working families wound up coming out ahead, except those in high-tax states who saw deductions for state and local income and property taxes slashed to just $10,000.

Some policies have always been a slap in the face to parents. For example, child support payments are nondeductible and nontaxable. Since child support is usually paid by the ex with the higher income, this means the money for the children is usually taxed at that parent's higher rate.

Some tax breaks for children are capped even for bigger families. For example, the Child and Dependent Care Credit currently gives working families up to $4,000 for daycare expenses for one child, $8,000 for two children, but nothing beyond that. Similarly, when it comes to college, the Lifetime Learning Tax Credit limits you to $10,000 in eligible tuition expenses per year, no matter how many scholars you're financing.

Speaking of college, paying that bill is a hugely different challenge for us than for Chinese families. Chinese universities typically cost $3,000 to $10,000 per year, with only one (Beijing's Central Academy of Drama) charging more than $16,000. Here in the U.S., the rack rate at the University of Chicago runs $80,163. It's just a matter of time before some school with the chops to get away with it cracks the six-figure line, and does it with a straight face. Forget about covering that bill with your run-of-the-mill 529 plan!

We're certainly not here to tell you how many children you can afford. Our job is to help you take advantage of every opportunity the tax code gives to keep more for them and their pricey schools, sports, hobbies, and other activities. So call us when you have questions, and enjoy your time with them until they think they've outgrown needing your money!

Interesting Time to Be In Real Estate

As the world leaves the 2020 Covid 19 crisis behind, we still live-in interesting times. Just a short but not conclusive list of things you cannot control in real estate.

• Price increases for materials

• Supply chain issues

• Skilled labor shortages

• Long term rental license and inspections

• Eviction laws and new proposals

• Increasing the capital gains tax to 43.4% on higher income households

• Abolishing the 1031 like-kind exchange transactions on real estate sales greater than $500K

• Not allowing the step-up basis on assets by the beneficiary on inherited assets

• Increasing federal, state, and local regulation

Changes are coming to the real estate investor fast. It is hard to keep up. Troy Miller, ICOR and our friends at the National Real Estate Investors Association (NREIA) are working diligently to keep you informed and fight for you about all the changes going on at the federal, state, and local levels. You should give them all the support you can muster. What can you control? You can maximize your legal tax deduction and save as much as cash as allowed by using a detailed strategic tax plan. It allows you to accomplish your personal objectives with pre-tax dollars. Any time you can pay for something in pre-tax dollars, you automatically win.

We all have personal objectives such as funding children’s education (home schooling, private tuition, or college), paying medical expenses, retiring the mortgage on your personal residence, or building your retirement nest egg. We all would like to improve our cash flows. What else could you do with the money, if you are not writing that check to the IRS?

Another advantage of the detailed tax plan is that it guarantees savings. You have identified the changes which you are going to implement. The plan allows to calculate the potential cash savings you are targeting. When you complete your tax return, you can measure the dollars you saved.

This tax plan should be in writing. Verbal advice is worth the paper it is printed on. It should tell you what to do, when to do it, how to do it and why to do it. The why is the most important. It describes where in the tax code, revenue procedures, and tax court cases it states that you can do it. This is the keystone to preparing a tax return where you can defend the information you report to the IRS. It is always good to be ready to explain why your deductions qualify under the tax law.

Although the risk of audit is historically low, the IRS is increasing its budget for performing audits by 40% this year. In addition, the President has proposed $80 Billion to enhance the IRS abilities to perform audits. You should be ready for the increased scrutiny.

The More Things Change…

The Biden administration has rolled out an ambitious set of tax hikes to support new spending on infrastructure, families, and other priorities. While the plan includes raising rates, much of the action focuses on closing loopholes, especially for corporations. But if you've ever had front-row seats to that particular horror show, you know that closing loopholes is like killing a vampire — much easier said than done!

Back in 1937, FDR launched a campaign against loopholes for the rich. Henry Morgenthau, his Treasury Secretary, prepared an 11-page memo, exposing strategies that the Depression-era 1% employed to pay less. It's a classic howl of righteous indignation, with sentiment straight out of the Occupy Wall Street movement. (We're waiting for a Ken Burns documentary.) So, what outrages did he find?

"The investigation of the income tax returns for each successive year reveals the increasingly stubborn fight of wealthy individuals and corporations against the payment of their fair share of the expenses of their Government . . . . But we still have too many cases of what I may call moral fraud — that is, the defeat of taxes through doubtful legal devices which have no real business purpose nor utility, and to which a downright honest man would not resort to reduce his taxes."

Morgenthau didn't just reveal how, he revealed who, in a way that would land today's Wiki-leakers in jail:  

• Charles Merrill and Edwin Lynch had 40 trust funds and 23 personal holding companies. "They operate a great many numbered brokerage accounts and only at the end of the year identify for whose benefit the account has been operated. In this way innumerable transactions are carried on between the different corporations and trusts which have no effect upon the beneficial interests of Merrill and Lynch, but which are designed to reduce their tax liability very greatly."

• George Westinghouse, Jr. "has a $3 million Bahamas corporation and in an attempt to prevent the Bureau of Internal Revenue from catching up with him, moves his home address from one small hamlet to another each year."

• "Alfred P. Sloan's yacht is owned by Rene Corporation, one of his personal holding companies, along with $3 million in securities. He rents the yacht from his company and the company uses its income from securities to pay depreciation on the yacht, the wages of the captain and crew, and the expenses of operating the yacht."

More generically, Morgenthau attacked percentage depletion as "perhaps the best example of legalized theft from the United States Treasury which the revenue laws still permit." Washington still hasn't seen fit to repeal it — just drive through Houston's stately River Oaks neighborhood to see what it's done for the oil business. And he marveled that "lawyers of high standing at the bar are advising their clients to utilize devious tax avoidance devices, and they are actually using them themselves." (No! Lawyers being clever? Say it ain't so!)

So, what's the answer? Garlic? Wolfsbane? Witchcraft? We'll see what they end up choosing this time. Regardless, our job remains the same: to navigate the new rules to help you pay less, legally, morally, and ethically. While you probably won't be able to rent your yacht from your company, we can be sure the new rules will include new "green lights" you can use to go without paying.