Tax planning time is usually the end of the year. But this year, between the uncertainties of the presidential election, the IRS working on eliminating some of our favorite tax-planning techniques, the current softness in the collector car market, and interest rates possibly going up, it makes sense for the savvy collector to start early on tax planning.
Today’s tax rates
You have probably noticed that income tax rates have gone up in the past couple of years. The maximum federal tax rate on ordinary income is up to 39.6%. We also have a 3.8% Net Investment Income Tax (NIIT) add-on that hits many investors. Then we have state income taxes, many of which run around 10% or more.
If you sell a collector car that you have owned for more than one year, your gain is taxable as a long-term capital gain. The maximum federal rate is 20% (we will come back to a recent development on the 28% rate). But add the 3.8% NIIT and say, a 10% state tax rate, and it can be a 33.8% total tax rate.
Estate taxes, meanwhile, have dropped. We now have a roughly $5.4 million exemption which is inflation-adjusted annually. A married couple can combine their exemptions and transfer around $10.8 million estate tax-free. Above that, it’s a flat 40% federal tax. That’s a lower estate tax burden than before for most people, but we also have state estate taxes to deal with — with highest honors going to Washington and its 19% maximum rate.
But here’s the big wrinkle: We’ve always used gifting as a way to save taxes, but today the benefits of gifting are not as clear.
Say, for example, you bought a Porsche Carrera GT new for $450,000. It’s worth about $1 million today. If you died and left it to your kids, your estate would pay estate tax on the $1 million value, but your kids could sell it right away and not pay any income tax. That is because of what we call the “basis step-up” at death. Since the Porsche is exposed to estate tax, your $450,000 basis “steps up” to the $1 million estate tax value.
If you give the Porsche to your kids while you’re still living, they keep your $450,000 basis. When they sell it for $1 million, they pay the income tax on the $550,000 gain. So, you might save some estate tax with the gift, but the kids end up paying the income tax. With income tax rates up and estate tax rates down, the differential has shrunken.
Taxes are inherently political, and it makes a huge difference which candidates get elected. Now that the race has narrowed down some, it is easier to focus on the possibilities. But it’s not as simple as picking the next president — we also have to consider which party is going to control the Congress — the Senate in particular and its 60% filibuster rule.
If Bernie Sanders wins, there’s little doubt he would push for higher income and estate tax rates. If we also have a Democratic-controlled Congress, it’s open season. If Hillary Clinton wins, one would expect the same push — although not as strong as Sanders’.
If a Republican wins — and we have a Republican-controlled Congress — we can probably say goodbye to the estate tax. There would be downward pressure on the income tax, but perhaps more so with capital-gain reduction. But if the Democrats control Congress, tax rates may stay much the same. Also, keep in mind that Donald Trump has not talked like a huge tax-cutter, and John Kasich is a budget-balancer who may need to preserve tax revenues.
Put all of this together, and it looks like waiting for lower rates doesn’t seem all that promising — and they could go up.
Some of our favorite tax-planning techniques, such as GRATs and sales to grantor trusts, are tied to interest rates. If interest rates rise, which most observers expect but can’t predict the timing, these techniques will not work as well as they do with today’s low rates.
One of our best tax planning techniques is the family limited partnership or LLC (FLP). By transferring your collector cars to an FLP, you can gift partial interests to your family and take advantage of substantial valuation discounts that can reduce the gift and estate tax value of the entire collection.
Here is a simple example of how an FLP could work: Say you transfer your $1 million car collection to an LLC. That is a tax-free transaction since you own 100% of the LLC.
Next, you give 10% of the LLC to each of your three kids, and 21% to your wife, leaving you 49%. The 10% gifts to each of the kids carry $100,000 of inherent value, but they are minority interests. As such, they would be valued on a discount basis at, say for example, $60,000.
The gift to your wife is tax-free due to your marital deduction. Your retained 49% interest is also a minority interest commanding the same discount. Add all the interests together, and you get about $600,000 of total gift and estate tax value, even though $1 million of cars are held in the LLC. That’s $400,000 of value that just slips through the cracks.
Our ability to achieve the valuation discounts is based upon the various design characteristics of the FLP that reduce the marketability and control of the ownership interests.
Some years ago, Congress adopted a provision known as §2704 that restricts our design flexibility in this regard. The major exception is that design characteristics that are generally provided under state law are all acceptable.
Once that exception became law, tax lawyers all around the country went to work changing their states’ laws so that the default provisions were all the ones we wanted to have to maximize valuation discounts.
The IRS hasn’t liked that, and they have been working on regulations that would limit our ability to rely on state law standards. They’ve recently been making noise that their new regulations are coming out “imminently.” Once the regulations come out, the benefits of FLPs will be reduced. But FLPs created before the regulations come out will almost certainly be grandfathered, so now is the time to act.
More on the hit list
Another useful technique is a grantor trust. This is a complicated trust to explain, but think of it as schizophrenic.
The trust beneficiaries are your kids, and transfers to the trust are completed gifts. However, the trust is designed so that the grantor trust rules treat you as the “owner” of the assets inside the trust for income tax purposes only. This sounds pretty weird, but pair it up with an FLP and you can do some great planning.
Start by transferring your car collection to an LLC owned 100% by you. Next, gift part of the LLC to a grantor trust established for your kids. Now, you and the trust share ownership of the LLC. However, for income tax purposes, you still own the LLC and it is disregarded for income tax purposes. Weird, yes, but stay with me.
Now you want to use the cars owned by the LLC. You hire an appraiser to tell you how much rent you have to pay to keep things at arm’s length.
But since you are considered the owner of the whole thing, you are essentially paying rent to yourself, so the rent does not produce taxable income. But the cash does go into the LLC, which uses it to pay the maintenance costs on the cars. (It goes without saying that your kids aren’t going to be helping with the expenses!) Put that all together, you’ve moved value out of your estate, everything is valued on a discount basis — and you are building wealth for your kids. Plus, you can still use the cars.
If you don’t want to make a big gift, you can sell part of the LLC to the trust for a note. It all still works the same way, but as the cars are sold, part of the proceeds go to the trust, and it uses the cash to pay down the debt owed to you.
As you may have guessed, these transactions are on the IRS hit list. They work today, but a big Democratic victory could cause them to disappear next year.
Selling cars this year
“Legal Files” has said repeatedly that the 20% long-term capital gains rate applies to sales of collector cars. The tax code does provide for a 28% rate on collectibles, but the tax-law definition of a “collectible” does not seem to include cars.
A recent case in the U.S. Tax Court involved exactly this issue, and we were eagerly anticipating the first case decision on the subject.
Before the battle could be fully drawn, the IRS conceded the case without explanation. That could mean that the IRS knew it was wrong. But it could also just mean that the IRS had some internal problem with case development and chose to wait to fight another day. We have no way of knowing. Either way, this case does not establish a precedent.
Savvy collectors will report and use the 20% rate — but will also obtain a formal legal opinion ahead of time to support the filing. That way, if the IRS does challenge and establish that the 28% rate applies, you should be protected from filing penalties. A legal opinion is pretty cheap insurance, and the cost is deductible to boot. ♦
John Draneas is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney. He can be reached through www.draneaslaw.com.