Avoiding Capital Gain Tax on Selling Appreciated Assets

Imagine you've been working and building a business for the past 20 years that can now be sold for, say, $20 million. Or perhaps, you've made some wise real estate investments and the properties can be sold for a big gain also.

You think to yourself, "This is great! I can finally cash out."

Then your tax adviser gives you the news that even though you have paid income tax on every dime of earnings, there will still be another tax on the appreciation of the asset values because of those earnings.

Wealth generally comes from either building up an operating business or from making investments. Putting capital — financial and human — at risk is what it takes to build value. Capital growth is not income.

But under our tax system, when the capital build-up is going to be realized by a sale or other transaction, then the government wants its piece of the pie as if it were a partner all along.

The fact that the government was paid income tax all along the way on the profits just doesn't count. There is no credit for income taxes previously paid against the capital gain taxes to be due.

And, of course, always hovering about like some ghoul is the estate tax.

The question from a tax planning perspective is how can you avoid paying capital gains tax and estate tax on money on which you have already paid income tax?

The answer is for many in this predicament is to utilize an estate planning technique to solve both the capital gain and estate tax problem.

It works like this.

The business owner or investor transfers his appreciated assets into a trust. It is established for the earlier of his death or 20 years. During his lifetime he can be the trustee. At his death or end of the term, a minimum of 10 percent of the value of the assets donated into the trust must be donated to a charity. Basically it's a toll charge for not paying the capital gains tax. However, the charity could be a private charitable foundation so even the toll charge is not really a loss.

But the charitable part is actually a real income tax benefit. The value of the remainder that must go to the charity creates a current income tax charitable deduction. If not phased out, the deduction creates an income tax savings. Those savings — the refund of income tax — are used to fund a second trust called a wealth replacement trust.

This trust buys life insurance using the tax savings. The financial effect is to create an enhanced estate value, nontaxable, that will be an amount much larger than the original amount that actually goes to the 10 percent charity designated in the first trust.

The person setting up the trust, the grantor, can receive payments out of the first trust (which holds 100 percent of the sale proceeds) in a couple of different ways: either a fixed amount of the initial value or a fixed percentage of the value of the trust determined annually must be paid out to the beneficiary. That is, the payments usually go to the grantor or his family.
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The government hopes that taxpayers are just lazy and will find it easiest just to pay tax on the gains from the sale of appreciated assets. Taxpayers who are smart will use this opportunity to create an even larger pool of investable money that will benefit themselves during life, provide a larger inheritance for the family and leave a legacy of charitable good deeds.