Mark is a successful 37-year-old entrepreneur with a $65 million net worth who is looking to minimize his taxes. In this article, we’ll walk through his situation, goals, and plans, and explain the logic behind each potential tax strategy.

Tax strategies have to be tailored to an individual’s circumstances and objectives. Since every individual’s circumstances and objectives are different, what makes sense for one person might not make sense for another. At the same time, there tends to be best practices given an individual’s net worth, liquidity, family situation and financial goals. That’s the idea behind Valur’s guided planner tool.

In Mark’s case, by pursuing three tax-efficient strategies, he’ll be able to more than double – and perhaps triple, depending on how long he lives – the amount of wealth that he is able to leave to his children.

What Are Mark’s Circumstances?

What Are His Goals?

Now that we have the basics on his situation, let’s review his goals in order of priority.

Mark’s Tax Plan

Given his situation and goals, here’s what he’s moving forward with:

Charitable Remainder Unitrust

First, Mark is setting up a five-year charitable remainder unitrust (“CRUT”) and will transfer around $10 million of the QSBS-eligible stock to it. A CRUT is a trust that distributes to the grantor (Mark) a predetermined percentage of the trust’s assets each year until the end of the trust’s term, at which point the remaining ~10% of the trust’s assets pass to a charity (or charities) that Mark chooses. Income generated inside a CRUT is tax deferred until it’s distributed to the grantor, though in Mark’s case the real value of the CRUT is its ability to qualify for its own $10 million QSBS exclusion.

Since the trust will qualify for its own $10 million capital gains exclusion thanks to the QSBS rules, there won’t be any capital gains tax when Mark sells the stock. Mark will receive about 90% of the principal, plus investment returns, back over the course of the five-year term. Only the investment returns (the growth on the assets above $10 million) will be subject to tax, and that tax will be deferred. Mark will also get a $1 million charitable income-tax deduction to offset his other income (which is worth about $500,000 to him today) and contribute about $1.3 million to a charity of his choice at the end of the CRUT’s term. After five years, Mark will personally have about $3 million more than he would have had without the CRUT. That initial gain will compound over the course of Mark’s lifetime.

Non-Grantor Trust

Second, Mark is setting up a non-grantor trust in South Dakota and transferring about $5 million of stock to it. This will leave Mark with about $10 million of stock in his own name, so that he can claim his full personal QSBS exclusion. A non-grantor trust is a type of trust that is treated as a separate taxpayer for income-tax purposes. As a separate taxpayer, the trust will also qualify for its own QSBS exclusion. 

In addition, since the trust will be a tax resident of a state with no income tax, like South Dakota or Nevada, future investment returns will also be exempt from state tax. The gift of stock will consume a portion of Mark’s $13.61 million lifetime gift tax exemption, though it will likely use less than $5 million. It will likely be appraised for about $3.5 million for gift-tax purposes due to it being a non-public stock that controls a minority of the company, which will leave Mark with a little over $10 million of unused gift-tax exemption.

Mark will lose direct access to the $5 million of stock in the non-grantor trust (he could borrow money from the trust but the interest will be taxable), and he won’t be able to act as trustee himself. But in return, he and his family will realize a number of substantial benefits. Mark will dictate the terms of the trust, including the identity of the beneficiaries and the trustee. He will name his parents and future descendants as beneficiaries, so that if they need anything, there’ll be a way to support them without any tax consequences. The trust will also be protected from Mark’s creditors. The trust will be permitted to invest in Mark’s next startup or whatever else Mark wants the trust to invest in. Most importantly, Mark will save his heirs $1.6 million of federal and state capital gains tax on the sale of his business now due to the additional QSBS exemption, plus he will avoid future state income taxes on the investment returns inside the trust, and because the appreciation will be outside of Mark’s estate for gift and estate tax purposes, upon his death this trust will save his heirs even more money on estate taxes. In other words, this strategy allows Mark to (a) get an additional QSBS exemption to avoid federal and state taxes now, (b) avoid state taxes in the future, and (c) avoid losing 40% or more to estate taxes.

Private Placement Life Insurance

Third, Mark considered two strategies for reducing the income tax liability generated by his alternative investments. Many alternative investments, like hedge funds and private credit, generate high returns along with significant ordinary income tax liability. Someone like Mark is likely paying close to — or more than — a 50% effective tax rate on that income. The two options he considered:

• Non-Grantor Trust: Mark could transfer the full $10 million alternative investment portfolio to his non-grantor trust. That would help him avoid state income taxes, lowering the effective tax rate on those investments from 50% to closer to 37%. It would also use a large chunk of Mark’s lifetime gift tax exemption, but he would have enough of his remaining gift tax exemption, after the gift to the non-grantor trust, to avoid gift taxes on this transfer.
• Private Placement Life Insurance (PPLI): An even more tax-efficient approach would be to set up a $10 million private placement life insurance (PPLI) policy and invest in the alternative investments through that. PPLI, like other types of life insurance policies, are exempt from both federal and state income and capital gains taxes. But compared to other forms of life insurance, PPLI has very low fees. In return for a death benefit and that tax-free growth, investors pay the insurance company around 50-70 basis points per year, plus one-time fees of around 200-300 basis points on the premiums/contributions. When combined with an irrevocable life insurance trust, PPLI can also yield enormous estate tax savings. Due to the income tax and estate tax savings, and the power of compound growth, PPLI can save investors (and their heirs) tens of millions of dollars (or more) over time.

Mark selected the PPLI option. He will be able to borrow from the policy and his future spouse can receive distributions from it as well, though ideally he will leave the investments alone to appreciate tax free.

Tax-Planning Tradeoffs

Tax planning strategies — which includes strategies for minimizing income tax as well as strategies for minimizing estate tax, gift tax and other taxes — involve tradeoffs. Most tax strategies involve putting away a portion of the taxpayer’s assets in a trust or some sort of investment structure that limits the taxpayer’s control and/or access to the transferred assets. There are also occasional tradeoffs between income-tax minimization and estate-tax minimization. Often, the most income-tax-efficient strategy is suboptimal from an estate-tax perspective, and vice versa, which is why it’s important to understand your goals.

Other Ideas

There is more that Mark could do:

He could set up an additional CRUT, transfer appreciated assets to it, and then sell the assets inside of the CRUT — he’d eventually have to pay the capital gains tax on the sale, but the tax would be deferred for years.

He could create zeroed-out GRATs and put publicly traded stocks in them — if the stocks appreciate, the excess returns above the IRS hurdle rate would pass to his beneficiaries free of gift tax.

He could also set up intentionally defective grantor trusts outside of his estate, transfer income-producing assets to them, and then pay the trusts’ income-tax bills — doing so would transfer assets out of his estate, but the IRS wouldn’t consider the payments to be gifts for gift-tax purposes. These strategies are covered elsewhere but are beyond the scope of this article. You can read more about them in our Learning Center.

Conclusion

Mark is obviously very fortunate, and even without tax planning he would be in a position to leave a large legacy to his family. But with smart tax planning, he can turbocharge that legacy. Valur is here to help.

About Valur

We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors. 

From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!