Wednesday, July 12, 2006

Financial Suicide

Something very sad occurred today. I wish I could say I had never seen something similar happen before, but I have. Seemingly smart people make financially devastating and irreversible choices.

The cause, I believe, is partly fear of something new to them, and partly the unwillingness to trust or listen to those professionals they have chosen to guide them.

I realize that once one is burned in a previous situation, it is harder to put yourself in someone's hands again at a later time. However, if you are faced with a potentially critical event, the worst thing you can do is take the path of least resistance when it is you who will suffer the consequences.

First, before I describe the essence of what I am witnessing, let me give an analogy.

Let's say you were diagnosed with a brain tumor that a specialist said was operable and your chances of pulling through and living a productive life were 95% in your favor. Surgery is a scary thought for anyone, and your brain is an important organ.

So, you get several professional opinions and they all agree this is your best chance of living a happy and healthy life. You, however, had a surgery many years ago that didn't turn out exactly as promised. Maybe a knee replacement that never really let you walk without a limp.

Now you distrust surgeons in general because you had an experience that didn't give you the exact results you were hoping for. You are in less pain than before the knee surgery, but not as good as before the original injury. It's left a sour taste in your mouth, so you prefer not to have another surgery ever again.

Your brain tumor will not go away however. Your choices are have the surgery with a very good chance of living a long life, or do nothing and let the tumor run its course. You might have 1 year, 10 years or 1 week left to live. Chances are the longer you live, the more eventual pain you will be in.

So, what do you do? Get over your fear of having another surgery, and most likely give yourself the gift of a longer life (taking into account that 5% chance there may be side effects or even death), or do nothing so you avoid surgery, and hope that some miracle occurs and you are healed and don't have to think about it anymore.

If this were your mom or dad and you loved them, which course of action would you encourage them to take? You can say, "it's your life" and stay out of it, or you can help them understand that it is in their best interests to have the operation so they are healthy and with you for years to come. Remember, this isn't a 50/50 chance here. It's 95/5 in favor of success.

Obviously, most would be in favor of the surgery. However, there are some that will not under any circumstances venture out of the "known" and will opt to let the tumor grow and take their life, rather than take the 95% chance of living comfortably.

Ok, this was a long road to make my original point. It is my business to put together a strategy for anyone facing a large capital gains tax consequence, so that they minimize their tax obligation and enjoy the maximum fruits of their labor when they sell an asset.

Without going into exact specifics, a potential client had a large real estate holding that was actually entrusted to two children years ago. The client no longer owned the asset. The kids did. The client wished the asset sold, so it was. The tax consequences were very large, as the kids had received it at the basis of the parents, which was very low.

The elderly remaining parent wanted control and liquidity of the proceeds. For some reason, they could not understand that they had lost control years ago. The children have control.

A Private Annuity Trust for each of the children is the best solution. It would give them each about 2800.00/mo after taxes for the rest of their lives. A loan could be taken to pay the parent's current mortgage, so the parent would have no payments to make. The kids are willing to give the parent the payments from the trust (gifting them) for the rest of the parent's life. So the parent would receive about $5600.00/mo with no taxes due as long as they lived. After the parent's death, the kids would continue to receive their $2800.00/mo after taxes for the rest of their lives. When the parent dies, the condo they live in can be sold to pay back the loan to the trust. There is a further complication of the property being held in an LLC if no trust is done.

This is an extremely cost effective way to take care the parent as long as they live. The taxes are spread out over about 30 years, so the majority of the funds are continuing to work in the kid's favor.

So here's the tragedy. The parent isn't familiar with the concepts of the PAT. Despite 2 CPA's, 2 Attorneys, and a Financial Advisor being in agreement this is the best method, the parent can only think liquidity and control are being lost. The kids, although highly educated, are inclined to do what the parent feels comfortable with rather than making their own informed decision as to how the parent is best taken care of financially.

If the asset is sold, taxes paid, and the remainder of the funds deposited in the LLC this is what will happen. For the parent to get any money from the proceeds, the kids will have to take the money first as income and pay income taxes on it before they can gift it to the parent. Since each makes a good salary, this means they will pay taxes again at about 40% when the money comes out of the LLC. So to give the parent $1000. they may have to draw out $1650.

When all is said and done, the parent will receive about 30 cents on the dollar for each payment they get. I really don't even know if they totally grasp this, although they have been informed.

Personally, I don't know why anyone would think this is the "simplest" choice. But then again, I'll take the 95% odds any day of the week. How many lottery tickets would I buy if I had a 95% of winning with each one? Let's just say I would not have to worry about money ever again...

Please don't let someone you care about commit financial suicide. Save them from themselves!

Paula Straub
SaveGainsTax
(760)917-0858