Alphabet Soup and Taxes

Sarah Simon Insights

With the increased government spending in response to the COVID-19 pandemic, some are speculating the stimulus may increase to as much as $8-$9 trillion in total[1]. There are several tax proposals being considered to finance this spending. While we are early in the speculation game, there are numerous proposals already being discussed, including higher tax rates and a reduced federal lifetime gift and estate tax exemption. There are some less-commonly discussed planning strategies that high-net-worth families may want to consider to potentially lessen the impact of these changes. While the following list is not exhaustive, some planning techniques to explore include:

  1. Investing capital gains in a Qualified Opportunity Zone (QOZ) fund. This type of investment allows you to defer income tax on re-invested capital gains and culminates in tax-free investments if certain conditions are met.
  2. Individuals and families with a net worth over $25 million may also want to consider two additional income tax planning strategies: Private Placement Life Insurance (PPLI) and the Malta Pension Plan (MPP).

QUALIFIED OPPORTUNITY ZONE INVESTMENTS

Qualified Opportunity Zones were created under the 2017 Tax Cuts and Jobs Act to revitalize economically distressed communities by using private investments rather than taxpayer dollars. To stimulate private participation, taxpayers who invest in QOZs are eligible to benefit from capital gains tax incentives available exclusively through this tax legislation.

The three primary tax and economic benefits of investing in a QOZ fund are:

  1. Tax Deferral: Investors can realize capital gains and defer paying the tax on those capital gains until as late as 2026.
  1. Tax Reduction:  In addition to the deferral, there is a reduction in the capital gains tax due in 2026 of up to 10 percent for investments held for 5 years.
  1. Tax Elimination: Capital gains generated by the QOZ fund’s investments are not taxed if the investment is held for 10 years.[2]  Other significant tax benefits include no depreciation recapture tax on most real estate assets, and the ability to distribute tax-free refinancing proceeds to investors in QOZ funds structured as pass-through vehicles.  Although the tax benefits can seem almost too good to be true, especially with the prospect of increasing tax rates, QOZ investments should only be made if the underlying investments in the fund are high quality. Discuss any QOZ investment with your financial advisor.

In response to the economic impact of the coronavirus pandemic, the federal government has extended the deadline for investors to place their funds into tax advantaged QOZ investments.  Although those investments usually must be made within 180 days of a gain event, individuals with a capital gains events between Oct. 4, 2019, and Jan. 17, 2020, now have until July 15, 2020, to invest [3] Individuals who were allocated capital gains in 2019 from underlying flow-through entity investments have until Sept. 11, 2020, in QOZ funds and reap the tax advantages.[4]

PRIVATE PLACEMENT LIFE INSURANCE (PPLI)

Because PPLI is essentially an income tax planning strategy, it should be particularly effective in the event of higher income tax rates in the future. PPLI provides a tax-free insurance wrapper with greater access and choice in investment strategy than retail life insurance. More specifically, PPLI is a type of variable universal life insurance that allows investments contained within the policy to grow, all while the income and capital gains taxes are deferred[5]. Ultimately, these deferred gains can be received income tax free at the passing of the insured in the form of a death benefit. If structured properly, individuals have the flexibility to make premium payments with public or private investments as well as cash contributions. Considering current market volatility, there is a benefit to exploring placing private assets into the policy, which are expected to have a significant “pop” in value to benefit from future tax-free growth.  There are several considerations and rules to evaluate, so it is important to discuss this strategy with your advisory team to determine if it is appropriate as part of your overall financial plan.

MALTA PENSION PLAN (MPP)

[6]  It is an optimal strategy for clients who have assets with low basis that have appreciated, or that are expected to have significant appreciation in the future.  The MPP takes advantage of the US-Malta Tax Treaty and allows individuals to provide for their retirement in a tax-deferred vehicle beyond what can be achieved via traditional retirement plans such as IRAs or 401(k)s.  The MPP is registered with and regulated by the Malta Financial Services Authority, a regulatory agency of the Maltese government.  The MPP is treated as a foreign grantor trust for U.S. tax purposes, and there are no statutory or regulatory limits on the size of contributions, although the contributions must be sourced from self-generated wealth. We generally recommend not contributing more than 30 percent of an individual’s net worth to an MPP. It can be particularly beneficial to fund a MPP with highly appreciated property. The reason is unrealized income, capital gains, and recapture taxes are not triggered by the contribution to a grantor trust.  Further earnings in the MPP are also tax deferred. The participating individual may receive an initial lump-sum distribution of up to 30 percent of the value of the MPP tax free any time after reaching age 50.  Beginning three years after the lump-sum distribution, additional annual lump-sum distributions of up to 50 percent in excess of a certain floor value of the MPP may also be received tax free.[7]  There are several factors, including cost and administrative steps, to determine if this strategy is appropriate.  If structured correctly, this strategy functions like a supercharged Roth IRA.

The alphabet soup of trust and estate/tax planning is not always easy to digest. Coordinate with your trusted advisors to determine if QOZ, PPLI, or a MPP may fit within the context of your goals-based plan.

Bread or crackers, anyone?

 

 

To learn more and discuss, please contact Sarah Simon: ssimon@cressetcapital.com

 

[1] Van Dam, Andrew.  ‘The U.S. has thrown more than $6 trillion at the coronavirus crisis. That number could grow.’, The Washington Post, April 2020.
[2] Please note that certain states, like California, do not recognize the QOZ tax treatment so please consult with your advisor on specific state tax consequences.
[3] https://www.bizjournals.com/sanjose/news/2020/04/16/irs-extends-deadline-to-invest-in-opportunity-zone.html
[4] https://www.irs.gov/pub/irs-drop/n-20-23.pdf
[5] An Introduction to Private Placement Insurance and Annuity Products, Zurich American Life Insurance Company
[6] https://www.floridabar.org/the-florida-bar-journal/using-income-tax-treaties-to-convert-taxable-income-into-nontaxable-distributions/
[7] https://www.floridabar.org/the-florida-bar-journal/using-income-tax-treaties-to-convert-taxable-income-into-nontaxable-distributions/

 

 


 

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