Sale of a Business: Using a New Pooled Income Fund to Shelter Capital Gains

Sale of a Business: Using a New Pooled Income Fund to Shelter Capital Gains By E. Ronald Lara, CFP April, 2018 - In the following article we are going to examine the benefits of a business owner selling their corporation and donating a percentage of the C Corporation stock into a young charitable Pooled Income Fund ( PIF ) The goal is to accomplish two things: 1. First is to avoid the significant capital gains tax on the sale of the business; 2. Secondly, using the tax deduction from donating shares to the PIF to shelter the tax when the business owner converts his/her traditional IRA into a Roth IRA. A Roth IRA is an individual retirement account allowing a person to set aside after-tax income up to a specified amount each year. Both earnings in the account and withdrawals after age 59½ are tax-free. Traditional IRAs and qualified plans can be converted into a Roth IRA. By converting a traditional IRA to a Roth IRA, any untaxed amounts that are rolled over to the Roth IRA are subject to income taxation. Thus the need for a tax deduction. A Pooled Income Fund (PIF) is a charitable trust that is operated by a community foundation or other public charity. Assets are donated to a PIF and the donor avoids the capital gain when the assets are sold by the PIF. The donor receives a valuation for the donation and is assigned a unit of participation. The donor retains an income interest and thereby is able to receive income distributed from the PIF for the rest of the donor s life and other individuals if desired, such as a spouse or children. Upon the death of the last beneficiary the assets are distributed to the charities as the donor had designated. The reason this is so attractive now is that the tax deduction is historically high for a PIF. To help illustrate, we are going to use examples of a business owner who is a married Fairfax County, Virginia resident (68, spouse 65) selling his corporation for $10 million. 1. #1 NO ACTION: In the first example we will assume that the seller of the business is taking no action and is paying the capital gains tax on the sale of the business in 2018. 2. #2 PIF & ROTH IRA: In the second example we will assume that he's transferring $1.5 million from his IRA into a Roth IRA and putting $6,800,000 of corporate stock into a new PIF in 2018 before the sale of the business. He selects to name himself, his spouse and their children (ages 35) as beneficiaries for the PIF s distributed income. The reason for using a PIF established in 2018 is that the IRS determines the interest rate to be used in determining the tax deduction for newly established Pooled Income Funds. The rate for 2018 is 1.40% a near record low rate thus a significantly higher tax deduction of 54.77% as opposed to a Charitable Remainder Unitrust of 10.30%. The main reason for the $6,800,000 contribution of corporate stock is to report a minimum $3,200,000 of capital gain to get his AGI up to $5,000,000 such that 30% of his AGI equals the maximum charitable tax deduction he can take in 2018 to offset the tax from the $1.5 million Roth IRA conversion. 1

Thus, how much capital gain must he report along with his current $300,000 AGI to shelter the $1,500,000 Roth IRA conversion? Thus, the ideal amount of capital gain to report is $3,200,000 and put the other $6,800,000 into a PIF. Let us now compute the tax deduction for our business owner age 68, spouse age 65 with children age 35 who is putting $6,800,000 of corporate stock into a PIF established in 2018. Current AGI $300,000 Roth IRA Conversion $1,500,000 Capital Gain $3,200,000 Total $5,000,000* *30% of this amount is $1,500,000 Note the payment rate shown is 1.4%, this is the rate set by the IRS, it is not the actual yield of the PIF. The actual yield will be determined by the PIF s investment performance, less fees and expenses. In this case we will assume the PIF yields 5.75% net. Distributions from a PIF are mandatory, typically quarterly, will vary and are treated as ordinary income to the beneficiary. Scenario Examples ASSUMPTIONS: Beneficiary Ages 68, 65 & 35 Principal Donated $6,800,000.00 Cost Basis of Property $100,000.00 Current Estimated Income Rate 5.75% Rate of Return Used for IRS Valuation 1.4% BENEFITS: Charitable Deduction $3,722,592.00 Estimated Payments in First Full Year $391,000.00 Let us now look at the tax results by selling his corporation and receiving a $10 million dollar capital gain. We also assume he has $300,000 of ordinary income and uses the new $24,000 standard deduction resulting in federal and state income taxes of $3,041,569 see below. Note the Medicare tax of $380,000 below on his capital gain, this is an additional 3.80% tax that just started in 2013. In our second example we look at the tax savings by putting $6,800,000 of corporate stock into a Pooled Income Fund before his sale. He receives the following benefits as illustrated in the example on the next page. #1 No Action #2 $6,800,000 PIF & Roth IRA Main Worksheet - years 2018 2019 2020 2018 2019 2020 Filing Status /Personal Exempt Joint/2 Joint/2 Joint/2 Joint/2 Joint/2 Joint/2 Ordinary Income $300,000 $647,922 $647,922 $1,800,000 $747,997 $747,997 Net Long-term Gain or Loss $10,000,000 0 0 $3,200,000 0 0 Adjusted Gross Income $10,300,000 $647,922 $647,922 $5,000,000 $747,997 $747,997 Itemized Deductions $1,510,000 $234,399 $234,399 Standard Deduction $24,000 $24,000 $24,000 Taxable Income $10,276,000 $623,922 $623,922 $3,490,000 $513,598 $513,598 Tentative Minimum Tax $2,070,028 $146,964 $146,964 $710,728 $112,153 $112,153 Medicare Tax @ 3.80% $380,000 $13,221 $13,221 $121,357 $16,796 $16,796 Net Federal Tax $2,450,028 $183,451 $183,451 $832,085 $147,934 $147,934 Resident State Tax $591,541 $36,546 $36,546 $207,977 $30,394 $30,394 Total Tax Liability $3,041,569 $219,997 $219,997 $1,040,062 $178,328 $178,328 Tax Savings $2,001,507 $41,669 $41,669 Net to invest $6,958,431 $2,159,938 (Assumed net avg. annual return) 5.00% 5.00% Annual Income $ 347,922 $ 107,997 Pooled Income Fund Income @ 5.0% $ 340,000 Additional Annual Income $ 347,922 $ 447,997 2

What has our smart donor achieved? First he has saved over $ 2,000,000 in federal, state and Medicare tax; Created an estimated $340,000 of annual income by putting the $6,800,000 into the PIF; Receives a $3.722 million dollar tax deduction. Using the tax deduction he was able to shelter the tax on his $1,500,000 conversion from his IRA into a Roth IRA, where it will continue to grow tax free and come out tax free for the rest of his life, his spouse s life and their children s lives; We are also assuming he earns 5% on the after tax proceeds from the sale of his business in future years. Note the additional $41,669 in tax savings in years 2 through 6 resulting from the charitable deduction carryforward. The business owner and spouse can then pass the Roth IRA on to their children where it will continue to grow tax free and come out tax free for the rest of their lives. This is huge. They have set up a benevolent gift to the charities of their choice. Note the additional $1,500,000 of income in the second example - this is the income from the Roth IRA conversion. Even with this additional $1,500,000 of additional income the owner still has saved $2,001,507 in federal and state income tax. From above we saw his charitable deduction was $3,722,592 and he only used $1,500,000 in 2018, thus he can carry forward the remaining $3,722,592- $1,500,000 = $2,222,592 charitable deduction and shelter 30% of his adjusted gross income for the next five years or for as long as his charitable carry forward lasts whichever is sooner. In the above case he saves an additional $ 41,669 in federal and state income taxes for the next five years or more than $200,000. Now let s look into the future and see how our business owner could fare by selling his business and taking no action. We will assume for all practical purpose that he will always be in the 36.5% federal and state tax bracket including the Medicare tax of 3.80%. We are assuming he takes no action will take the proceeds from the sale of his business and subtract the taxes of $3,041,569 and invest the remaining $6,958,431 to produce an average annual net return of 5.00%, producing $347,921 of annual income. However, our donor will also have the income from his tax savings of $2,001,507 x 5.00% = an additional $100,075 annually. For the next five years we can use the remaining charitable deduction carry forward to shelter 30% of his AGI, thus due to his charitable tax deduction carry forward he will save an additional $41,669 in taxes each year through 2023 Future Economic Benefits To The Owner And His Family. We will assume he and his wife live to age 92 and at that time the income from the $6,800,000 in the Pooled Income Fund goes to their children. Owners IRA Assets, If He Takes No Action As he is age 68 there are no required minimum distributions from his IRA until he turns 70 ½. At age 70 ½ he must start to take required minimum distributions from his IRA. We are assuming their joint life mortality is 25 years. After they both pass away their children receive the inherited IRA and they must start to take minimum distributions from the inherited IRA based on their life expectancy and pay federal and state income taxes on those IRA distributions. We have assumed a 6.00% annual growth rate on his IRA assets and a 36.5% combined federal, state and Medicare tax rate: No Action Taken End of Year Tax on Amount to IRA end of Age IRA RMD Factor Withdrawal Withdrawal Spend/Invest Year Value 68 1,500,000 0 0 0 1,590,000 69 1,590,000 0 0 0 1,685,400 70 1,685,400 27.4 61,511 22,451 39,059 1,725,013 3

71 1,725,013 26.5 65,095 23,760 41,335 1,763,419 72 1,763,419 25.6 68,884 25,142 43,741 1,800,341 [ results break] 88 1,936,407 12.7 152,473 55,653 96,820 1,900,118 89 1,900,118 12.0 158,343 57,795 100,548 1,855,782 90 1,855,782 11.4 162,788 59,418 103,370 1,804,341 91 1,804,341 10.8 167,069 60,980 106,089 1,745,533 92 1,745,533 10.2 171,131 62,463 108,668 1,679,134 2,625,334 958,247 1,667,087 By converting their IRA to a Roth IRA they receive an additional $958,247 spendable income from their Roth IRA, that they would have paid income taxes if it had stayed in a regular IRA, along with the additional $ 100,000 annually from the tax savings at 5% for 25 years gives them $2,500,000 plus the $958,247 from the Roth IRA for a total of over nearly $3,500,000 in additional income or $140,000 annually for 25 years. Now let s look at the total income their children could receive from the Roth IRA: Children's RMD's Single Life End of Year Tax on Amount to IRA end of Age IRA RMD Factor Withdrawal Withdrawal Spend/Invest Year Value 61 $ 1,679,134 25.2 $66,632 $19,990 $46,643 $1,713,250 62 1,713,250 24.2 70,795 21,239 49,557 1,745,249 63 1,745,249 23.2 75,226 22,568 52,658 1,774,738 64 1,774,738 22.2 79,943 23,983 55,960 1,801,279 65 1,801,279 21.2 84,966 25,490 59,476 1,824,390 [ results break] 80 1,357,724 6.2 218,988 65,696 153,291 1,220,200 81 1,220,200 5.2 234,654 70,396 164,258 1,058,758 82 1,058,758 4.2 252,085 75,626 176,460 870,198 83 870,198 3.2 271,937 81,581 190,356 650,473 84 650,473 2.2 295,670 88,701 206,969 393,832 85 393,832 1.2 328,193 98,458 229,735 89,269 86 89,269 0.2 89,269 26,781 62,488 0 $4,024,147 $1,207,244 $2,816,903 By converting their IRA to a Roth IRA their children receive an additional $1,207,244 in spendable income. Lastly, I want to show you the effect of the Roth IRA conversion to their children. Keep in mind once their parents have passed away the children must start to take withdrawals from their inherited IRA based on their single life expectancy. In our example we are assuming the children are 61 when their parents pass away their single life expectancy is 25.2 years, thus whatever the balance in the IRA is when they inherit it must be divided by 25.2 in the first year and then in each succeeding year one less for example in the second year the factor is 24.2 the year after 23.2 and so on. They must pay federal and state 4

income taxes on their IRA distributions BUT our smart donor who used his tax deduction to shelter the tax on his Roth IRA conversion is leaving his children with a Roth IRA that requires the distribution to be made using the same factor but there is NO tax on distributions from a Roth IRA. Also because our Smart donor did the Roth IRA conversion he did not have to do a required minimum distribution as the owner who did not do the Roth IRA conversion thus his Roth IRA was worth considerably more upon their deaths. Let s first look at the owner who took no withdrawals from his Roth IRA and let it grow @ 6.0% for 25 years, again we assume a 6.00% annual growth rate. In 25 years it grows to $6,437,806 which they pass on to their children and grandchildren. We are assuming their children are now age 61 when they inherit their parents Roth IRA. Let s look at the spreadsheet and prepare yourself to be amazed. Children's Roth IRA Distributions with no parents RMD's Beginning Year End of Year Years Age Roth IRA Factor Withdrawal Roth IRA 25 61 $ 6,437,806 25.2 $255,468 $6,568,606 26 62 6,568,606 24.2 271,430 6,691,292 27 63 6,691,292 23.2 288,418 6,804,352 28 64 6,804,352 22.2 306,502 6,906,111 29 65 6,906,111 21.2 325,760 6,994,718 30 66 6,994,718 20.2 346,273 7,068,127 42 78 6,024,579 8.2 734,705 5,651,349 [ results break] 45 81 4,678,251 5.2 899,664 4,059,283 46 82 4,059,283 4.2 966,496 3,336,344 47 83 3,336,344 3.2 1,042,607 2,493,917 48 84 2,493,917 2.2 1,133,599 1,509,953 49 85 1,509,953 1.2 1,258,294 342,256 50 86 342,256 0.2 342,256 - $15,428,593 Wow, if the parents elect to not take any distributions from their Roth IRA and let it grow for the rest of their lives their children wind up receiving over $ 15.4 million dollars TAX FREE from their inherited Roth IRA. This is $12.6 million dollars more than their children would receive if they did not follow this strategy. BOTTOM LINE Anyone selling their business or appreciated stock should look into using some of the charitable giving strategies that are available today to shelter that tax due on sale of a business or capital asset and use the tax deduction to offset the tax due on a Roth IRA conversion. Call Ron Lara at 703-761-3901 or 970-668-5702 to ask questions, generate a detailed analysis for your particular situation and discuss with your tax professional. 5

ABOUT RON Ron is Founder and President of Lara, May & Associates, LLC ( LMA ), a dually registered independent broker/dealer and investment advisory firm. Ron is a seasoned, senior-level advisor with over 40 years of financial planning and investment management experience. He is a graduate of the University of Maryland with a Bachelor of Science degree in Civil Engineering. Ron knows math. He s often referred to as having a computer brain. Ron is the lead investment manager to the Charitable Success Solution Pooled Income Fund. www.laramayllc.com information@laramayllc.com This article has been prepared for general illustrative purposes. Data has not been verified and is subject human error. You should not act upon this information without obtaining specific advice from your tax professional. This information was not intended to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. The author, LMA, its members, employees, and agents shall not be responsible for any loss sustained by any person or entity that relies on the information contained in herein. This information may not be current and the author has no obligation to provide any updates or changes. Accordingly, certain aspects may be superseded as new guidance or interpretations emerge. Donors are strongly encouraged to consult with their own tax professional with respect to tax questions or considerations. Actual data will vary and may not be reflected here. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. Assets donated to a PIF are not an investment but a donation to a charitable organization and are irrevocable. Income produced by a PIF is typically paid out quarterly, is subject to the underlying performance of the PIF, including expenses and fees, and will vary. The income distributions provided to the beneficiary should not be relied upon as a primary income source and are taxable as ordinary income. Lara, May & Associates, LLC FINRA/SIPC Member. 6