Tax advising for the high-net-worth client, part 1

It isn’t what you make. It’s what you keep. Tax planning is an integral part of your service offerings for high-net-worth (HNW) clients, typically someone who has at least $1 million in liquid assets. Clients hire you for more than tax preparation; they want your guidance and planning advice. It’s your role as their trusted advisor to help satisfy their demands and make their money work for them, while still complying with tax rules and regulations.

HNW clients require a different approach to tax advisory. Tax planning is not an annual event – it’s an ongoing conversation throughout the year and requires constant contact. Even the slightest lack of communication could end up costing your client more problems than the solutions you provide.

Before you can make recommendations regarding tax strategy, I recommend asking a lot of questions, listening to your clients, and taking the time to get to know them. This time is well spent because it helps you provide the proper level of insight necessary to do what you do best. 

Questions to ask your clients should cover the following:

• Overall financial goals: What are you trying to accomplish?
• Retirement goals: What does retirement look like, and do you have enough put away to outlive your money?
• Charitable giving goals: How philanthropic do you want to be?
• Personal family lifestyle changes: Does marriage, divorce, or some other major life event affect tax planning?
• Legacy/wealth transfer to their family: Have you adequately planned for the future of your family?
• Are you expecting a significant increase in income this year, next year, or in the future?
• Are you expecting a liquidity event, such as the sale of a significant asset or business?

The answers to these and other questions will tell you what your client needs, and will help you develop short-term, intermediate, and long-term strategies you can summarize and present to your client. As your relationship grows, you can provide even more insight. Planning can often be challenging when initially working with HNW clients because most don’t perceive themselves as wealthy, don’t generally think beyond next year’s tax bill, and more than anything, don’t want to be surprised about their tax situation at the end of the year.

Your role as a trusted advisor is to provide them with potential issues and suggested solutions. This requires a fundamental shift in the planning process for you and your clients. More difficult, you have to properly advise your clients why this shift is necessary in their own mind. 

One way to do this is to build your tax planning conversations with your client’s financial and business advisors – their investment advisor, estate planning attorney, and business attorneys. Each one will have a different goal. The investment advisor’s goal is to maximize the client’s return on investments, while your goal is to minimize the tax implications on investment transactions. The estate planning attorney aims to optimize your client’s trust planning, asset protection, and simplified wealth management. Your goal is to minimize any potential estate tax implications. The business owner’s goal is to maximize the value of the client’s business, while minimizing net profit on which potential tax is due.

Here are some of the more-common strategies to implement and execute for your client. Keep in mind the list is not meant to be all-inclusive. It is incumbent on you to prepare the proper strategy based on their own individual needs. It may be your client requires an entire suite of services, just one, or a combination.

Tax planning for investments

If your client is an employee and their company offers deferred compensation plans, such as a 401k and/or traditional/pre-tax and Roth/post-tax plans, advise them to maximize their contributions. This strategy potentially lowers taxable income based on which 401k they participate in, and by setting aside more for retirement in a 401k plan, their maximum dollar amount to contribute is $19,500/year if they are less than 50 years of age. They are eligible to contribute an additional $6,000 if they are 50 years of age or older.

By keeping investments inside tax-advantaged accounts, they may be limited to contribution amounts due to income limitations or participation in employer retirement plans. Keep this in mind when recommending these tax-advantaged accounts in your overall plan.

You can also work with your client and their investment advisor to consider “investment loss harvesting,” a strategy to sell securities at a loss to offset a capital gains tax liability. You will need to consider the timing of the market and how to match the type of investment capital losses to the type of investment capital gains, such as long-term vs. short-term gains.

However, there are some downsides to this strategy. First, it is incredibly difficult, if not impossible, to time the market. In addition to the opportunity cost, and continual monitoring of the market and the client’s portfolio, there could be additional and unexpected tax costs. If the client doesn’t have capital gains to offset against the capital losses, they can only use capital losses of up to $3,000 to offset against ordinary income. Any remaining capital losses are carried forward to future tax years. In addition, selling an investment at a loss solely for the sake of tax savings isn’t an efficient use of their money and may not align with their overall investment strategy.

“Buy, Borrow, Die” is another investment strategy used for long-term investing, and estate planning and tax minimization. In this scenario, the client buys something, such as stock, real estate, or a business. As long as the client doesn’t sell the asset, they owe no tax. The client borrows money from a bank or other lending institution that offers an interest rate lower than the expected rate of return on the asset. The loan is collateralized by the purchased asset. The client uses the loan proceeds to fund their lifestyle, and the client pays the principal and interest expense. The interest expense may be deductible for tax purposes. Upon the client’s death, the estate, including the asset, goes to the client’s heirs. The associated loan is paid off. The asset gets a step-up in basis, which reduces potential tax to the client’s heirs.

This idea may seem a bit out of the ordinary, but it is similar in nature to a home equity loan that is typically used to fund major purchases or renovations to one’s home.

Tax planning for business owners

If your client is a business owner, you can recommend several tax strategies, including SIMPLE (Savings Incentive Match Plan for Employees) IRAs, SEPs (Simplified Employee Plans), and solo 401ks. These strategies allow for the business owner to contribute up to $58,000 (in 2021) toward these retirement accounts each year. There are considerations when implementing these types of investment accounts. Make sure to do your research, and work with your client and their investment advisor to understand the benefits, risks, and requirements of each type of investment/retirement account.

Another retirement option to consider for your business owner client is a Defined Benefit Plan. This plan allows the business owner to set aside much more money for retirement than the typical IRA or 401k, and can typically be funded in a shorter time period than the IRA, 401k, and SEP. The annual contribution is determined by actuarial assumptions based on age, investment return, and other factors. In many circumstances, annual contribution limits can be very high – possibly in the six-figure amounts based on the business owner’s age at the date of inception of the plan. This contribution is fully deductible as a business expense. The business owner can also deduct up to $500 for setup fees.

An additional tax strategy may be to hire the business owner’s spouse as an employee. This will enable the business to contribute additional funds, subject to actuarial assumptions, on the spouse’s behalf. By hiring the spouse and funding their share of the defined benefit plan, net income is further lowered, resulting in lower income tax.

A defined benefit plan is not without risks! The business owner is required to make a minimum funding contribution every year, and the funding requirement is not contingent on how much money the business makes in the calendar year. Even if the company has a bad year, the business owner is still required to fund the defined benefit plan. In addition, the administrative fees are usually higher than 401k, SEP, or IRA plans. However, as long as the amount funded each year is at least the minimum required amount, a great strategy is to vary the funding amount to lower net taxable income. It will be important to work with the client to discuss cash flow considerations, and work with the client’s investment advisor to set up and monitor the plan.

Business owners also have additional tax-saving strategies to consider. For example, the choice of entity – a limited liability company, S corporation, or C corporation – may be worth re-evaluating because it might make sense from a tax perspective to change entities. However, make sure that the tax savings your client may realize makes sense relative to the other reasons for the initially selected entity. Here is where it would be important to involve the client’s business attorney. Always remind the client that not all business decisions should be made solely to save tax dollars.

You can also work with your client to manage their net income to maximize their qualified business income deduction (QBI). Ways to manage the QBI include deferring income or accelerating expenses, structuring compensation/bonuses, and determining optimal amounts of defined benefit contributions or retirement contributions.

In part two of tax advising for the HNW clients, we’ll cover tax planning for charitable giving, and gift and estate tax planning. Stay tuned.