Tuesday, December 04, 2007

Case Study for Lump Sum Distribution Tax Reduction

Ask anyone in the tax business and they will tell you the worst way to be taxed is as ordinary income. This is because (with the possible exception of some corporate rates) you will pay tax at the highest rates in effect.

I’ve had several clients receive large sums of compensation in 2007. The reasons range from a pension or deferred compensation lump sum payout that was unavoidable, to a large lump sum that resulted from a business sale payout package.

Once income is received there is no way to defer the tax due. However, there may very well be a way to minimize it. Let’s look at a real life example.

Client Mark received a lump sum income distribution of 1 million dollars in 2007 from a business sale. He was going to owe close to 45% in income tax, or 450K. That would have left him with only 550K to retire on.

Since the taxable event had already occurred, his only option was to try and reduce the 450K tax bill.

This was accomplished with a Charitable Installment Bargain Sale. The idea was to get a large tax deduction to reduce the income tax due and then receive a guaranteed income stream over a period of 25 years.

Of the million dollar income, 750K was placed in a Charitable Bargain Sale with an initial donation of 75K cash to the charity. This was able to generate a 509K tax deduction when calculated using the 25year installment payout option for the remainder.

Even with the IRS rules for charitable deductions on high income earners, Mark will be able to reduce his AGI by almost 50% in 2007 using his tax deduction. He will receive monthly payments of $4,227.60 for 25 years for a total return on his 750K of $1,268,280.00 and his tax bill will be reduced by at least 50% for 2007 and be closer to 225K, for an immediate 225K tax savings.

That’s close to one quarter of one million dollars of immediate tax savings, and his income stream will be partially non taxable, as he has already paid tax on the principle. Only the interest component will be taxable as ordinary income in future years.

Every case is different, and including your tax advisor in the planning process is essential. All aspects of your situation should be considered, as well as estate and retirement planning needs.

It is definitely worth exploring your options when a large sum of income is accrued in one calendar year, especially if you are nearing retirement and will be needing as much of this money as possible to sustain your future income.

Be sure to put something in place prior to December 31sr . If you wait past the end of the tax year you will owe all of the tax in April.

Paula Straub
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