Transactional Planning
Jan discusses the concepts of transactional planning and provides some specific examples of how transactional planning not only protects your assets but minimizes tax exposures domestically and internationally.
Jan provides an overview of the strategies of entities, timing, location and strategy to ensure income is characterized properly and achieved in the right location and in the right timing to accomplish your goals and objectives. US Taxpayers are taxed on their income worldwide. Jan discusses the use of “PIGS,” Passive Income Generators” and “PALS,” Passive Activity Losses, are used to realize gains and offset losses in order to minimize taxable income.
Jan
Welcome to AB cast integrating legal tax accounting and business solutions. I’m Janathan Allen.
In Episode four, we will be Discussing transactional planning.
Neil
Jan. We’re about to get into what’s a really interesting and complex concept. How would you describe transactional planning?
Jan
Transactional planning is really a phrase that I’ve adopted to create an integrative plan through the substantive areas of tax accounting and law that organizes an individual’s assets, whether they be tangible assets or intangible assets, currency, real estate, whatever assets and individual owns into a structure that does two things. It mitigates risk and it minimizes tax.
Neil
So what would you consider to be the first step in transactional planning?
Jan
There are a couple of elements in the first step and the first step is to begin to understand what the client’s motivation and short, mid and long term plans for life are. And within those plans, where is, and what are the assets that the client currently holds? What types of assets are held and the fair market value and income that may be created or thrown off from those assets. It’s very similar to the marshaling of assets, let’s say, in an estate, except the individual is very much alive.
Neil
Once you understand a client’s objectives, where do you go from there?
Jan
The next step is to ascertain how it is that the assets are held. For example, I have clients that will, I own real estate, and some of them have put that real estate into a limited liability company. Some haven’t some have investments that may be held, for example, in a money market account. Some may have assets such as ownership and a company that is currently operational and a company for which they work. So it’s an organization and recognition of the types of assets that are held and how it is that they’re held and then the development of a plan as to how they should be held. And what that means in general is for example, if a client comes to me and they have several rental properties, one of the things that I would advise them is if the properties are not held in a limited liability company, my advice would be to go back and create limited liability companies in order to put the assets, to shield them from potential litigation and thus mitigate risk.
That might be one step. The second step would be after taking a look at the assets and how it is that they should be held and what entities should hold them, how it is that those entities may interact with one and another. And I’ll give you a brief example about that. For example, if I go back to my real estate example and a client comes to me with real estate assets and we put them into an LLC, the LLC throws off a type of income called passive income in the internal revenue service. There are three baskets of income, there’s investment income, there’s active income, and there’s passive income. And to the extent that passive investment and active income are taxed differently, what the goal is, is to provide the client with the most advantageous entity for holding of the asset, that will do two things, mitigate risk and thus minimize tax.
If I continue on with the real estate example, for example, if I’m going to put real estate into an LLC and the income from that LLC is passive income. I may want to convert some of that passive income to active income. And I do that by creating an entity such as an S corporation or a C corporation that may hold an ownership interest in the LLC. That’s when the LLC has passive income that flows through to the S Corp or to the C corporation, such as for management fees, that income is converted from passive income to active income, with active income. I can go back and utilize typical tax tools for deductions to defer tax on active income that I’m unable to do with passive income simply because of the IRS rules relating to the differing types of, so the structure of how the asset is held and the types of structures that are holding the assets become a paramount importance in creating the transactional plan and the organization of those assets into differing types of entities become critical to the transactional plan.
Neil
So Jan, building on that real estate example you’ve laid out beautifully, let’s get into the different types of income and how they’re taxed
Jan
Continuing with the real estate example, the terms that I generally use in describing the types of income that flow from, for example, an LLC are pigs and pals, pigs are passive income generators. So for example, if you have real estate and it’s in an LLC and it’s for, um, investment purposes, then that LLC will be a passive income generator. The income that flows from that LLC will be passive income, hence its a pig. If I take that example one step further and I take a look at the same LLC and because the LLC has the ability to depreciate assets that are held within it, if the depreciation, which is a non-cash item is deducted from the income that is generated in the LLC and that depreciation exceeds the income. Sometimes there’s a loss that’s generated that loss that’s generated is called a pal, a passive activity loss. So you can passive income, which is a pig, or you can have a passive loss, which is a pal. And it’s the combination of those two, the, the offsetting of the pigs and the pals to get to zero sum, which allows us great flexibility in terms of tax planning when we’re putting together entities and a transactional plan.
Neil
So is the objective of a transactional plan to basically balance pigs and pals.
Jan
The objective of a transactional plan is to minimize tax. And so yes, to the extent that I can offset pigs and pals, varying LLCs, some with income, some with losses to get to zero, then yes, that would be, that would be one direction and reason for the creation of LLCs in a transactional plan, but LLCs can also hold active income. So I don’t want to give the impression that if I create an LLC, the income generated from that LLC always be passive because it is possible to create an LLC that has active income, but the LLC and the S corporation have differing characteristics from, for example, a C corporation. And so for tax planning and transactional planning, because transactional planning is really the accomplishing of mitigating risk and minimizing tax. If I’m looking at the creation of a C corporation as opposed to an S or an LLC, the reason that I would look at differing entities is because I can utilize a fiscal year end for example, with a C corporation that I’m unable to use with an LLC or an S Corp for me when I go back and I do tax planning, it’s really critically important for me to be able to accelerate income or losses into periods that will defer the income, the furthest.
So for example, you know, that your tax returns and your individual tax return is always taxed on a calendar year, that same calendar year true for an S corporation and an LLC. It does not hold true for an S Corp. We are, or I’m sorry, a C Corp you’re able to utilize a fiscal year end for example, let’s pick July for a C corporation, which I’m unable to do for an S an individual or an LLC. So when you get to the end of your taxable year, your individual tax year, and you want to take a bonus, but you don’t want to, you don’t want to pay taxes on that bonus. In that year, you can accelerate it from a C corporation into the following year, the next day, and have the money in hand and not have to pay taxes on it for another year. So it’s the distinction between the timing of when it is taxes due and the calendar year end or the fiscal year end of a entity and the entity type that allows us to do further tax planning along with the differing types of income buckets. So it’s really a, uh, a view of the types of, of income generated by the assets held by the client and the timing that can be created by the use of differing types of entities that allow us to create a comprehensive, transactional plan that leads to tax minimization.
Neil
So in effect, we’re able to accelerate income into a current tax year or defer it, and the same with losses based on what we need to minimize our tax exposure in a given tax year.
Jan
That’s right.
Neil
And Jan you’ve often told me it’s not just when income is realized, it’s where
Jan
Exactly, and where income is realized can be determined by where for example, domestically an entity is created. So for example, if I live in California, but I own real estate say in the state of Montana, I wouldn’t necessarily own a California LLC. I would create a Montana. I’ll see, by the same token, if I have assets outside of the country, I wouldn’t utilize a us entity to hold foreign assets. It’s the holding of foreign assets that makes a transactional plan far more complex because of the differing types of reporting that are required for the holding of foreign assets, the types of entities that can be created worldwide, how it is that they’re taxed in the foreign country and how it is that they’re taxed in the us all become parts of the jigsaw puzzle when you’re putting together an international tax transactional plan.
Neil
So Jan, you’re saying one key to transactional planning is where an entity is formed. This really matters.
Jan
Yes. And the types of entities that are formed is critical as well, but where the entities are formed, for example, domestically is of great importance as well. Those same assets. For example, if you hold assets outside of the United States and we have foreign assets, the types of assets and where entities are formed to hold those assets worldwide become important because of the reporting requirements, tax reporting requirements for us S and holding foreign assets. So for if I go back and I want to create a company, and let’s say, I wanna create a company in CZE Slovakia, the types of entities that are allowed under the Czech government are different than what we are allowed to create here in the United States. So it’s really of great importance to ensure that if I want an entity to be taxed in a certain manner, that I understand the foreign entities and how it is, they are viewed through the IRS’s lens because it’s through the IRS code that, that tax, that foreign tax entity that’s created will be determined by the characteristics and the, the closeness of those characteristics to us entities. And that’s how the entity will be viewed from the IRS perspective.
Neil
Jan, one of my biggest questions is if I have offshore property and I’ve got income that I’ve realized internationally on what that money in the United States, so I can spend it here. Is it taxable when I bring it in? What’s my exposure. And how does that transactional planning work?
Jan
Well, surprisingly, the income from offshore assets is not necessarily taxed when you bring it into the United States. In fact, it may be taxed far earlier than the at. So one of the misnomers and misperceptions that people have is if I have an asset outside of the United States and I don’t bring the money into the United States, then it’s not taxable and that’s not true. There are several expats that we have as clients, for example, that have moved outside of the United States, say for positions elsewhere in the world and presume that because they were outside of the United States, they no longer had a taxable reporting requirement and that’s not true either. So a simple example would be, if you are a us citizen, you may be living outside United States. You may have created a company, an operational company, maybe you’re producing product. Maybe you’re providing a service and you’re providing a service, pick a country anywhere in the world.
Um, let’s start with the UK. And because you’re in the UK, the assumption is since that entity is taxable in the UK, it wouldn’t be taxable here in the us. And that’s not true because in the us, as a us citizen, the reporting requirement for holding a foreign entity is the filing of form 54 71. If it’s a deemed to be a corporation or 35 20, if it’s deemed to be a trust or a flow through entity, that then requires the income that’s earned from that foreign entity to be taxed on your us tax return here in the states, the avoidance of that tax is achieved through bilateral tax treaties between countries. So it’s not as though you will pay tax. For example, in the UK and the us by utilizing treaties and putting together a comprehensive international tax plan, you can minimize the tax and avoid double taxation simply by using the tools such as the types of entities, the countries, where the entities are created and tax treaties to achieve the ultimate end of minimizing tax.
Neil
Even if you’re an American citizen,
Jan
Even if you’re an American citizen.
Neil
Jan, let’s just cover a few quick scenarios. Let’s say we have a husband and wife or domestic partners that own a couple of rental real estate properties here in the us.
Jan
When you look at individuals that hold only domestic assets, then a transactional plan can be simple, or it can be complex if the assets are held and the couple live entirely within one state. So for example, let’s take a California couple who own real estate in California. Then the transactional plan is fairly straightforward, but let’s go back and add a kink to it and say that they’ve decided to diversify, and they’re going to go back and invest in real estate throughout the us. Uh, maybe they’re investing say and opportunity zones, which were created, um, in 2017 that are investment opportunities that are us wide, the tax transactional planning then because of the diversification of states, that is somewhere other than the state of California can make a tax plan or tax transactional plan and more complex that will involve the types of entities that are allowed. And the taxation of those entities among states that do tax those entities. There are states that, of course, don’t go back and have any state tax. And so again, the, the choice of the type of entity where the entity is created, and the asset is held, becomes a primary importance in terms of a domestic transactional plan.
Neil
So if I hear you, right, you’re helping our clients understand not only how to structure their transactions, but where
Jan
Absolutely. That’s a key part of the transactional plan. For example, I had a client approach me a couple of months ago, and they wanted to move into doing operations from Southern California into the UK. And the reason that they were going into the UK was because they wanted access into the EU. They had been in the UK and had created, had talked to UK council and created a UK company. And it was after the creation of that UK company that I sat down with them. And we were talking about transactional planning. The first question that I asked was if they wanted entree into the EU, why did they create a UK company? Because the English company with resulting Brexit and the regulatory disaster that occurred after the pullout makes it far more difficult to have access through England than it would if they had, for example, created the company in Ireland, Ireland still maintains its ties with the EU. And my suggestion to them was to go back and dissolve the UK company, the English company, and form it in Ireland. So indeed the where the, the place of the creation of the entity can be as important as the type of entity in creating an international transactional plan.
Neil
But that’s also true domestically.
Jan
Yes.
Neil
So transactional planning really does apply to individuals as well as entities, domestic and international.
Jan
Absolutely. It isn’t just an individual and it isn’t just an entity. It applies across the board. Anytime you’re going back and you’re creating a plan because of the holding of differing types of assets, the goal is to minimize your risk. And then we do that with the entity creation and minimize tax. And we do that with the types of income that can be generated by the varying types of entities. So it’s an overall encompassing plan in harmonizing, the differing types of entities, the incomes and losses that may be created and where those entities are created that go back and lead to a successful transactional plan.
Neil
Thanks, Jan,
Jan
Anytime
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