Just as in sports, the wealthy know that for growing or maintaining wealth a good defense is just as important as a good offense.
In financial terms, for growing wealth, not only is it important to increase income but it’s equally important to protect that income from the IRS.
Just as zealous as the wealthy are about growing their proverbial “pot,” they are equally fervent about defending that pot from being chipped away by taxes.
That’s why they employ strategies and exert extreme amounts of effort or hire professionals to implement strategies for protecting their wealth.
So, what are some of the tax strategies the wealthy employ to minimize their tax bill and protect their wealth?
We will explore a few of the more effective and interesting of those strategies. Be advised that the information provided in this article is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice.
1. Avoid Ordinary Income
The wealthy avoid ordinary income at all costs and with the highest individual tax rate at 39.5% who can blame them? To avoid ordinary income, instead of working a regular job, the wealthy put their time and energy into investments. The two classes of investments they favor are running a business and real estate investments.
It’s no secret that running a business entitles the owner to significant tax benefits through deductions. Business owners can claim potential tax deductions for all kinds of business expenses including vehicles, meals, travel, office supplies, advertising, courses, and a home office.
Like running a business, real estate investing also enjoys many tax benefits, with the acquisition, repair, and operational costs deductible and/or depreciable over time. In addition, any tax on the gain from the increase in value from the sale of a property can be avoided through either a 1031 exchange or in the case where a 1031 exchange is waived; the profit will be taxed at the capital gains rate, which tops out at 20%.
Where ordinary income can’t be avoided, such as those in high-level management or executive positions, if given the option, many of these individuals prefer to tip their compensation towards deferred compensation in the form of stock options instead of salary. Stock options are not taxable until exercised so if structured correctly, income can be deferred out for a significant length of time.
2. Borrowing as a Strategy
Taking a page out of Apple, Inc.’s playbook, the wealthy frequently use the power of leverage to avoid paying taxes. In the case of Apple, which is sitting on a foreign cash pile of over $250 billion, it is far more cost-effective to borrow against that pile of cash to meet its cash needs such as for stock buybacks than to repatriate those funds into the U.S. and have to pay the taxes on those funds.
The wealthy employ this exact same strategy, just in different ways. If they own a business, there are many types of business loans available to extract the value of the company without selling it. Loans secured by hard assets of the company against receivables are common and frequently taken advantage of by the wealthy.
Taking out loans against real estate is also a favored tactic of the wealthy. Instead of extracting value from a property by selling it and incurring capital gains, the wealthy will often prefer to take out a loan against the real estate at a lower rate than what it will cost them in taxes to sell it. The added benefit of this approach is that the owner can keep the property and all built-in and future equity.
Borrowing as a strategy is not exclusive to business owners and real estate investors. Employees and executives, especially those individuals with significant deferred compensation in the form of stock options, also employ this strategy. Because stock options are not taxed until exercised, many individuals will hold off on exercising those options even after the options have vested.
Loans against stock options are now common; instead of exercising their vested options, then selling the stock and incurring capital gains to buy a home or car, many employees will opt to take out a loan against those options to meet their cash needs. With this strategy, they don’t have to forego any future equity by exercising options and selling stock. Taking out a loan allows the employee to receive cash but retain the upside from the stock.
3. Creative Strategies
Out of all the myriad of creative strategies employed by the wealthy to avoid taxes, one of the most interesting and effective is the hiring of children to work in their businesses. The tax benefits can be significant. If you hire your children as employees to do legitimate work in your business, you may deduct their salaries from your business income as a business expense. Moreover, if your child is under 18, you won’t have to withhold or pay any FICA (Social Security or Medicare) tax on their income. This is a great tool for shifting part of your business income from your tax bracket to your child’s bracket, which should be substantially lower than your own.
Your child can earn up to $12,000 tax-free.
That’s because they only pay tax on their income only to the extent it exceeds the standard deduction amount for the year. For 2018, that amount is $12,000 for single taxpayers. In other words, your child can earn up to $12,000 (that’s $1,000 per month) and not owe any taxes on that income.
Think of about this…
Instead of paying for a car or private school tuition out of your after-tax income; you can have your child pay for that car or part of their private school tuition with tax-free dollars earned on income that can be deducted by your business as a business expense.
In the end, the wealthy are wealthy not only because they know how to generate income but also because they know how to protect it.
They have a good offense as well as a killer defense. The good news for the rest of us is the tools used by the wealthy are not exclusive to them. Many of these same tactics are available to everyone else and if done right, can reduce an individual’s tax bill significantly.
These tools can be especially beneficial for real estate investors who decide to build a business around these investments. By employing creative strategies such as hiring their children to reduce their tax burden and when cash is needed; instead of cashing out a property, leveraging that property in the form of a loan to avoid a tax bill will go a long way in creating and preserving wealth.
Tax burdens can be reduced significantly with the right strategies.