Optimal numbers in tax planningArticle added by Nicholas Paleveda MBA J.D. LL.M on March 6, 2013
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Sanford, NC

Joined: March 27, 2012

Taxes are about numbers, where a percentage of net earnings is sent to the federal or state government based on perceived success. The theory is, the more success one has in the economic game, the more they should contribute to the common good in the form of taxation. Theoretical models have been built by academics as to tax structures; see Brito, Hamilton, Slutsky, Stiglitz, Pareto Efficient Tax Structures 1990 SSRN working paper 3288. However, like most academic papers, it is based on models that do not comport with reality and current tax planning.

Most individuals wish to optimize the highest amount of earnings for themselves and the least amount of taxation sent to the government. The code actually provides optimal numbers for tax planning; however, very little research takes place in this area. This article is an attempt to open up the discussion for using optimal formula clauses, adjustment clauses and compensation in various areas of tax planning. Hence, it will be useful for tax practitioners as well as academics who devote more time to the research and development of tax planning.

Optimal numbers in retirement planning

I first came across optimal numbers working with enrolled actuaries who specialize in ERISA. The world of enrolled actuaries is quite small. According to Google, there are about 4,700 enrolled actuaries in the U.S. Enrolled actuaries are the only profession that is allowed to sign schedule SB or MB, the valuation schedules for defined benefit pension plans. Tax attorneys, CPAs and other tax professionals are not allowed to sign this schedule. The exams are extremely difficult, allowing a pass rate of about 17 percent per exam for individuals who are used to scoring 800 on the math section of the SAT or GRE. The test follows the lines of MEGA and TITAN, found on the MEGA SOCIETY website. Demographically, this is a unique group of individuals.

Optimal number for retirement plans

The optimal number for compensation in 2012 was $200,000 for individuals who can and have the ability to set their own salary. The reason is that this is the maximum considered compensation under ERISA for benefits purposes. If you take any salary data above this number, your benefits and tax deductible contributions to a qualified plan will not increase. If you take salary data below this, your benefits and tax deductible contributions will decrease. For example, person A, age 55, makes a gross amount of $517,888 a year. Person A comes to you and asks how much he should take out in salary and how much should or could be deferred into qualified plans. After a quick review of the internal revenue code, the following observation is made:

Person A should take a salary of $200,000 a year, assuming there is no Watson issue. Person A then could fund X amount until age 65, which will provide him a lifetime income of $200,000 for the rest of his life. If A decreases his salary to $190,000, he can only fund an amount X, which will provide him a $190,000 salary for the rest of his life at age 65; hence a lower amount will be funded on a tax deductible basis into his plan. If A increases his salary to $250,000, he will be able to fund X amount that will provide him an income of $200,000 for the rest of his life. Hence, $200,000 is an optimal salary number for him.

In terms of X, the tax deductible funding amount into a pension plan, this number is calculated on either using actuarial assumptions or guaranteed interest rates from pension annuities and annuity conversion rates, or annuity purchase rates (APR). An annuity purchase rate is the amount Person A would pay to an insurance company to provide a guaranteed income for the rest of his life.
For example, assume the APR is 0.00513. This is the amount per thousand/per month an insurance company will pay for benefits at age 65. To provide a monthly income of $16,666 (which translates to $200,000 a year), the employee in a pension plan would need to accumulate $3,248,733 as a lump sum (LS). In order to accumulate $3,248,733 in a plan in 10 years, the participant would need to contribute $283,388.70 each year for 10 years (assuming a 3 percent interest rate guarantee). Hence, Person A would take home $200,000 in salary and defer $283,388.70 in the pension plan, consuming $483,388.70 of A’s $517,888 gross income and leaving $34,550, which could be placed into another qualified plan.

The Pension Protection Act of 2006 allows the taxpayer to maintain a profit sharing plan along with the defined benefit plan. The profit sharing plan is limited to 6 percent of pay, if the defined benefit plan is not covered by the Pension Benefit Guarantee Corporation (PBGC) or 25 percent of pay to a maximum of $50,000, if the defined benefit plan is covered by the PBGC. Person A could set up a profit sharing plan, place $12,000 into the plan (6 percent x 200,000 = $12,000), set up a 401(k) profit sharing plan and deduct/defer $22,500 into the 401(k), wiping out $34,500 of gross income, leaving additional tax on $50.00.

Optimal numbers in tax planning have simple math but complex laws. For example, if Taxpayer A is 56 years old (as opposed to 55 years old), the benefit formula must be reduced 10 percent each year the taxpayer does not fund for 10 years, meaning the maximum benefit is $180,000 as opposed to $200,000, and the optimal salary is now $180,000. Another complication is that the maximum considered compensation under ERISA for testing purposes, including profit sharing contributions, is not $200,000, but $250,000. Taxpayer A would be able to contribute $15,000 to the profit sharing plan, as opposed to $12,000 if A increases his or her salary to $250,000. In addition, if A has a common law employee, the percentage of pay on which a formula can be drafted for testing purposes is $250,000, as opposed to $200,000, which would reduce plan contributions to an employee 0.796 percent.

So an argument can be made that the optimal compensation for a self-employed individual is $200,000 if he or she has no employees, or $250,000 if he or she has employees.

Optimal numbers for estate planning

In 2013, the American Tax payer Relief Act of 2012 came into effect. In 2012, $5,120,000 was exempt from the federal estate tax (indexed). But what do you do with an amount over $5,120,000? Case law suggests an adjustment clause could be used where the excess goes to a spouse or to a charity.

Adjustment clause

Adjustment clauses, or formula clauses, are given to us on a silver platter in the Wandry case. For example, I gift and bequeath 900,000 limited partnership shares with a value of $5,400,000. If the IRS does not agree with the value, the share value will be adjusted to reflect such valuation, as stated in Wandry.

I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my units as a member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such units for federal gift tax purposes shall be as follows:

Name — gift amount

Kenneth D. Wandry — $261,000

Cynthia A. Wandry — 261,000

Jason K. Wandry — 261,000

Jared S. Wandry — 261,000

Grandchild A — 11,000

Grandchild B — 11,000

Grandchild — C 11,000

Grandchild — D 11,000

Grandchild E — 11,000

Total: 1,099,000

Although the number of units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.
Furthermore, the value determined is subject to challenge by the Internal Revenue Service (IRS). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted units shall be adjusted accordingly so that the value of the number of units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation re-determination by the IRS and/or a court of law.

The adjustment clause (or formula clause) has also been upheld in Estate of Petter v. Commissioner, T.C. Memo. 2009-280:

Section 1.1 of Terry's transfer document reads: “Transferor assigns to the trust as a gift the number of units... that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and Transferor assigns to [the charitable foundation] as a gift to the [charitable foundation] the difference between the total number of unites [940 units] and the number of units... assigned to the trust.”

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value stood as a constant, which means that both before and after the IRS audit the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the taxpayer’s transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive.


Even though the bulk of advanced estate planning will center on the use of family limited partnerships, other aspects will be reviewed, such as trusts beyond the revocable living trusts, irrevocable life insurance trusts, like IRA conduit trusts, retirement plan distributions, special use valuation under 2032A, the alternate valuation date, contingent private foundations and finally, Section 6166.
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