Loopholes Soften Tax Bite on Rich

Tax hikes in President Clinton’s budget will take a big bite out of high-income taxpayers. But, surprisingly, the plan also creates a few loopholes for the wealthy. Combine those with some tested tax-planning ideas, and rich folks may be able to save a bundle.

The tax act hits the rich in several ways. First, it increases the top marginal tax rate to 36% from 31%. It adds a surtax--a tax on a tax--of 10% on income over $250,000. It lifts the ceiling on Medicare tax payments, so high-income filers will pay an additional 1.45% on income over $135,000. (They’ll pay 2.9% more if they’re self employed.) And the law makes permanent limitations on deductions and personal exemptions for high-income filers.

What can you do?

Some time-honored strategies that made sense before the Clinton plan continue to be advisable. These include shifting income to your children, contributing to a retirement plan, deferring income, donating appreciated property, prepaying deductible expenses such as mortgage payments or property tax, investing in municipal bonds or low-income housing and making an estate plan.

Here are some other ideas that have also gained added importance, or that are created by the Clinton plan.

* Get a refund on the luxury tax. The tax bill had plenty of retroactive taxes, but it also provided one retroactive tax break. If you bought high-priced boats, planes, furs or jewelry in 1993, you can get back any luxury taxes paid. (The luxury tax on cars costing more than $30,000 remains, but it’s now indexed for inflation.)

You can get a refund by going back to the store where you bought the item. The store will give you the money and the government will reimburse the store, the Internal Revenue Service says. (Practically speaking, some experts think merchants will give you the money only when they get it. But you’ve got to go through them to apply.)

Obviously, the value of this break varies based on luxury taxes already paid. But it can be substantial. If you bought a $20,000 fur, you paid a $1,000 luxury tax. For a $500,000 private plane, you paid $25,000 in luxury tax. For a $250,000 boat, you coughed up another $15,000.

* Make your children financially independent. If you earn more than about $285,000, your personal exemptions are completely phased out permanently under the Clinton budget. So the hot tax-planning idea is to give those exemptions--worth $2,350 today--to someone who can use them, says Gregg Ritchie, partner at KPMG Peat Marwick in Los Angeles. In the process, you create an independent taxpayer, who gets a standard deduction of $3,700 as well.

How do you do that? You stop providing more than half of your children’s support and, instead, allow them the means to support themselves. Better, you can still control the purse strings, if you use a family limited partnership.

Here’s how they work: Let’s say you have an income-producing property that you’ll eventually want to leave to your four children. You set up a family partnership, making yourself the general partner and your kids limited partners. You use your gift tax exclusion to deed them $10,000 interests in the partnership each year and allocate the appropriate amount of income to each partner. You then use the children’s income to pay their expenses--food, clothing, entertainment, doctor’s bills, etc.

You can provide their rent for free as long as the market value of that rent amounts to less than 50% of their support, Ritchie says. Any unused income can be accrued within the partnership--outside the little ones’ grasp--for a set period, perhaps 10 or 20 years.

What does that do to your tax return? Let’s say you give each child assets that throw off $20,000 in income each year, a total of $80,000. Market value of their rent amounts to $500 a month, or $6,000 a year. The rest of their expenses totals $10,000 a year.

You pay these expenses for the children, using the partnership income. The children then file their own tax returns. After standard deductions and personal exemptions, they each have $13,950 in taxable income and they each pay about $2,000 in tax.

You, on the other hand, have $80,000 less in income. But your expenses aren’t any higher because the kids are paying their own way. Since all of that $80,000 would have been taxable at your rates--to be conservative, say 36%--you saved $28,800. Taking into account the taxes the kids paid, the family is about $20,000 richer.

But beware: Setting up a family limited partnership is complicated and costly. But with the higher tax rates, they may now be finally worth a serious look.

* Opt for incentive stock options. If you can choose between pay and incentive stock options, the tax act may skew you toward the options. That’s because the net gain on incentive stock options are taxed at capital gains rates (which stay at a maximum of 28% under the Clinton budget), while your cash bonuses are taxed at ordinary rates (as high as 39.6%, with surtax).

However, beware of the onerous alternative minimum tax when you exercise the option. Option gains are a so-called “preference item” that must be added into taxable income used to calculate the AMT.

* Emphasize long-term capital gains. With capital gains rates remaining at 28%, $10,000 in interest earnings (taxed at ordinary rates) cost you between $3,600 and $4,400 in tax, while a $10,000 gain costs $2,800--a savings of $800 to $1,600. Be careful, though. The lower rate applies only to investments held more than a year. Short-term capital gains are taxed at your ordinary rates.

Less Taxing

Several time-honored tax strategies that made sense before President Clinton’s budget continue to be advisable for the wealthy--and not so wealthy. These include:

* Shift income to your children.

* Contribute to a tax-favored retirement plan.

* Defer income.

* Donate appreciated property.

* Prepay deductible expenses.

* Consider municipal bonds.

* Consider investing in low-income housing.

* Create an estate plan.