Too often clients who sell major assets, including businesses, real estate, large stock positions, artwork, and airplanes, fail to do their tax planning in advance.

For example, a few months ago we mentioned a case in which the client had realized a $50 million gain. Then, after the fact, he turned to his advisor tax advice.

The failure to plan in advance cost him millions of dollars.

The basic facts of the case are as follows:

1. Client sold a business for $50 million
2. Client had a basis of $1 million
3. Client lives in California
4. Client is 67, married, with children
5. Goal is to keep as much as he can for himself and his family

Base Case Right Now

Because the seller is a California resident this year, and sold his business this year, California will tax his gain at 13.3%, on top of the Federal capital gains tax of 20%, and on top of the Obamacare or NII tax of 3.8%. We originally estimated his total tax rate at 37.1%. Further discussion revealed that the actual effective rate was even higher, because some of the gains were subject to recapture. Thus, on the taxable gain of $49 million, he will (absent any other planning) owe approximately $20 million of income taxes.

Missed Opportunity

If the client had sought pre-sale planning, it would have been possible to create and fund a tax-exempt Business Owner Trust. This trust would have paid 5% income per year to the seller, then his wife, for their joint lives, and then to the client’s two adult children for their entire lives.

The client could have contributed any amount of his stock before the sale to the trust. All the way up to the entire $50 million. That means he could have paid zero tax. This is correct. If he had planned in advance, he could have paid zero tax on the sale.

Impossible to Eliminate the Tax

Even if the client were willing (which he is not, nor would we or most other advisors think he should be) to give the entire $50 million to charity, he would still owe about $7.2 million in taxes. That is because of the deduction limitations.

Second-Best Planning

The best time to plan is well before a sale. While there is no way to generate an outcome as good as could have been obtained with pre-sale planning, we are nevertheless able to help the client, and his advisor, get to a much better place than the current $20 million of tax the client will owe if he does no planning.

Hurry, This Opportunity Won’t Last!

Given the client’s age and his wife’s age, a section 642 tax exempt trust could be a second-best alternative for the client. Our recommendation was that the client contribute approximately $39 million to a qualified tax-exempt 642 trust.

His tax bill would drop from $20 million to approximately $12 million.

Given the ages involved and the various deduction limits and calculations (see here for a brief explanation on deduction limits), this level of contribution will reduce his taxes as much as possible, while still leaving him enough cash to pay the taxes he cannot avoid.

The client and his wife will then receive all the income generated from the $39 million, for as long as either of them lives.

IRS Tables Haven’t Adjusted, But they Will

Until the end of 2023, the deduction permitted for certain section 642 trusts is unusually large. That’s because of a quirk in the way the government calculates a certain interest rate that is involved in the deduction calculation, combined with the historically rapid increase in interest rates that the Fed has implemented. The quirk will go away on January 1, 2024.

If you have a client who you think might benefit, it is literally the case that now is the time to pursue it.

It is relatively unusual that a section 642 trust is the best solution. But in situations like this, when the client has already realized the gain, and the amounts are large (say, over $10 million), 642 can be a good “second best” solution. To learn more about it, please call us at 703 437 9720, and ask for Connor or Katherine.