Most of us have a broad range of clients in our practices. Some of our clients have large assets and now want to dispose of those assets. They might have started a business with sweat equity and now want to retire or exit the business. They might have purchased a publicly-traded stock, such as Amazon, Apple or Microsoft in the early days and hold a very large position in the stock. They may want to diversify their portfolio due to the inadvertently large concentration of assets in one stock. There may be many reasons they want to sell the large asset.
Let’s look at a typical client and the standard result. Then, let’s look at a few alternative solutions. Mary invested $10,000, buying 1,000 shares in a little-known company, LittleCo, a couple decades ago, shortly after it went public. Today that investment is worth $3.5 million. Early investors in Amazon, Apple and Microsoft would have a similar story to tell. Let’s say Mary is 60 years of age and wishes to quit work. Mary has no other income and wishes to volunteer for her favorite charity. She needs to sell her shares of LittleCo to raise funds for her retirement. If Mary were to sell all her stock, she would realize a capital gain on the difference between the sale price of $3.5 million and the purchase price of $10,000, for a gain of $3,490,000. This would result in the vast majority of the gains, more than 94%, being in the 20% capital gains bracket. Additionally, she will pay a 3.8% tax on net investment income above $200,000, for a total federal income tax rate of 23.8% on more than 94% of the gain. Also, this taxation would not be deferred, except perhaps to the following April 15.
But, there are ways to minimize the taxes. To understand how, it’s helpful to understand the capital gains rate structure and the 3.8% net investment income surtax. Capital gains are taxed at preferential rates. Currently, when a taxpayer has less than $37,950 in income, they are taxed at 0% for capital gains. This means that a single taxpayer with no other income could have $37,950 of capital gains income and pay no federal income taxes on it. If they are in higher income tax brackets for ordinary income, the capital gain would be taxed at 15% or 20%.
Next, let’s look at the 3.8% net investment surtax. The 3.8% surtax became law in 2010 as part of the Affordable Care Act, also known as Obamacare. When Republicans gained control of the White House, the House of Representatives, and the Senate after the 2016 elections, it appeared the Affordable Care Act and the 3.8% surtax on net investment income would be quickly repealed. Republicans in the House of Representatives, led by Speaker Paul Ryan, put together a replacement plan, the American Health Care Act, which would have removed the 3.8% surtax on net investment income, as well as dismantling much of Obamacare. However, Republicans could not agree on the measure. So, minutes before a re-scheduled vote on Friday, March 24, Speaker Ryan pulled the legislation from consideration. So, the 3.8% surtax, and the rest of Obamacare, are here to stay, at least for now. Of course, in this era of political surprises, nothing seems certain. But, at least for now, planning must take the 3.8% surtax into consideration.
Now, back to Mary’s conundrum. One alternative solution is for Mary to sell the stock over many years. For example, Mary could sell 1/20th of her stock, or 50 shares, each year for 20 years. Assuming the shares remained the same price, every year she would have proceeds of $175,000 from the sale, $174,500 of which would be capital gain. More than 21% of the income would be taxed at 0%, and the remainder would be taxed at only 15%. There would be no 3.8% surtax. However, with this alternative, Mary would face the risk that LittleCo shares could decrease in value and her portfolio would not be diversified for years to come.
Another solution is for Mary to sell all her stock to another investor in an installment sale in which Mary receives payments periodically over the years. For example, she could structure the installments to receive $175,000 every year for 20 years. In that case, Mary would recognize $174,500 of gain and $500 as a return of basis on each year’s payment. Thus, from a tax perspective, this would be the same as selling 50 shares each year. While Mary would no longer have exposure to the volatility of LittleCo shares, she would be subject to the risk that the purchaser might default on the obligation.
A better solution for Mary may be for her to give all her LittleCo shares to a Charitable Remainder Annuity Trust. The trust could pay her $200,000 per year for 20 years (given current interest rates). The CRT could sell the stock, diversifying its holdings. Mary’s payments would be flavored by the income earned by the CRT over the years. Assuming the CRT invests for capital appreciation, then her payments would be characterized as capital gain. She would pay 0% tax on about 19% of the $200,000 distribution each year and 15% on almost all the rest. (There may be a few thousand dollars taxed at 20%.) At the end of the 20 years, whatever is left in the CRT would go to Mary’s favorite charity. In addition, Mary would receive an income tax charitable deduction for more than $411,000 in the year of the contribution. Of course, she could not use this all in one year because of limitations. But, she could carry the unused portion forward for the following five years.
By using a CRT, Mary would achieve her objective of diversifying her portfolio. In addition, rather than having more than 94% of the proceeds taxed at 23.8%, most of the proceeds would be taxed at 15%, and 19% of the proceeds would not be taxed at all. Further, the taxation of the proceeds would be deferred into future years when Mary receives the payments. Of course, Mary also would receive a charitable deduction worth thousands of dollars each year for the first several years. Even better, Mary would know she’s helped her favorite charity.
The attorneys in our firm are experienced in all aspects of estate and income tax planning and charitable giving. As a member of the American Academy of Estate Planning Attorneys, our firm is kept up-to-date with information regarding all types of estate planning strategies and tools. You can receive more information about a complimentary review of your clients’ estate plans by calling our office at (408) 356-9200 or (831) 476-2400.