Tax Diversification Strategies

The Situation

In pass-through entities such as S corporations, LLCs, and partnerships, business owners are taxed on company earnings whether or not those earnings are distributed. When income is retained in the business or invested for future use, taxes on dividends, capital gains, or withdrawals can significantly impact long-term growth.

When cash is needed later, selling assets or withdrawing funds may trigger income or capital gains taxes. Just as diversifying investments helps reduce market risk, tax diversification can help optimize income regardless of future tax environments.

Common Planning Alternatives

• Qualified retirement plans: Employer-sponsored plans allow owners to make pre-tax contributions that reduce current taxable income, while also providing benefits to employees. Contribution rules generally require participation by non-owners.
• Individual Retirement Accounts (IRAs): IRAs may allow tax-deductible contributions, though deductibility can be limited based on income and participation in employer plans.

Tax-Deferred Growth Options

When tax-deductible contributions are limited, many business owners explore tax-deferred assets that allow earnings to grow without current taxation, keeping more dollars invested over time.

• Growth within qualified retirement plans and IRAs
• Deferred annuities
• Non-dividend-paying securities that may appreciate without ongoing tax liability
• Real property, which may offer tax deferral but can involve other ongoing taxes

Tax-Free Income Strategies

• Municipal bonds: Certain bonds provide tax-free income at the federal level and sometimes at the state level.
• Roth IRAs: Contributions are not deductible, but earnings grow tax-deferred and qualified distributions are tax-free when conditions are met.
• Permanent life insurance: When a death benefit is needed, permanent life insurance can provide tax-deferred growth and potential tax-free access to policy cash values.

Life Insurance and Tax Diversification

• Policy cash surrender values may be accessed income-tax-free up to cost basis, provided the policy is not classified as a Modified Endowment Contract (MEC).
• Once cost basis is reached, policy loans may be taken against remaining cash value.
• Cash values and death benefits are reduced by outstanding loans and accumulated interest.

These strategies may be especially valuable when future tax rates or personal income levels are expected to be higher. While taxes are an important planning consideration, financial decisions should not be driven by tax concerns alone.

Consultation with a Certified Public Accountant is strongly recommended to evaluate the tax implications of any strategy.