Accumulated Cash Enables Carried Interest Tax Treatment - Optimal?

[mr_orange]

So we're starting to amass a nice little nest egg of cash from our business operations of late.  DW and I still currently work a W2 and thus have ordinary income in addition to more favorable capital gains treatment from our real estate operations. 

We can deploy the cash to tax-favored accounts using a whole litany of techniques discussed ad nauseam on this site.  The general philosophy we have had throughout our working lives is to keep our cash at work in tax-favored accounts during our accumulation phase because it sits idly otherwise and the purchasing power decreases as inflation erodes it in real terms.  I am starting to question this overall philosophy as we are getting wealthier, primarily because of the way taxes are structured in our country.  The less cash I have the more dependence I have on earned income at a given time or at the very least short-term capital gains.  More cash means we can be compensated via compensatory shares in a fund or a promote that falls into the "carried interest" discussion of taxes.  With a bigger mound of cash it is easier for me to defer compensation and thus reduce taxes from the ordinary income rate (high) to long-term capital gains (low). 

Any thoughts on this?  Note that we're real estate investors and I also invest in small companies as well so this choice of how to be paid and when definitely applies to us.  Does it make sense to keep significantly more cash than I would ordinarily if my plan is to make the leap to full-time investing at some point in the future?  Would doing something like increasing a line of credit, keeping the cash at work, and structuring current effort as carried interest make more sense due to a loan from a line of credit not being a taxable event?

Edit: I did the math using our blended OI rate and what I think our long-term capital gains rate will be at the difference is roughly 7%.  So I think we are penalized by 7% or so for needing to structure our income as earned income as opposed to long-term capital gains. 

[DaveR]

Taxes are a bitch, but any way you look at it, you are better off reducing earned income and shifting as much as possible to capital gains. If that means using cash instead of collecting ordinary income, then I think it makes sense. As long as you aren't deferring that income such that you screw yourself in the future (e.g. $100k each of the next two years vs. defer $100k from this year to next and the pay taxes on $200k next year at a higher marginal rate).

Does your OI rate include the payroll tax (FICA, medicare) burden? 7% penalty seems low, since there are 7.65% payroll taxes. Unless your OI is strictly unearned income.

I'm in a similar situation, but have the added bonus of having control of a good portion of the W2 wages. Too much cash has been an issue this year and I've had to spend some time reconfiguring cash flow (reducing ordinary income). It least a bit of good luck has kept inflation low recently so cash hasn't eroded horribly. The key to holding "cash" is to stash it in TIPS, CDs, HY savings, or something income generating and not stuffed in the mattress.

[mr_orange]

Our tax situation is horrendously complicated.  The IRS thinks we're a half-breed and the tax laws for us straddle the business world and the W2 world.  It's all sorts of fun trying to figure it out each year.  I probably spend half the year doing the taxes for last year and the other half planning for the next year. 

We don't really have a FICA tax issue currently because we are both working.  Unfortunately we both make just less than the phase-out on social security and can't really convert to earned income to get money into our SoloK without increasing payroll taxes.  There is a big MMM thread about this in the tax forum. 

I spoke with my accountant today (which I do far more than I want to) and some other buddies of mine.  I don't think we can use carried interest to help out for our debt fund because those dollars will be taxed as OI anyway.  We could possibly use it for development projects, but the intent (dealer issues) is probably going to be a problem.  This may force us to do longer-term commercial projects sooner, which is probably a good thing anyway. 

[DaveR]

I hear ya...my accountant and I are way too cozy right now, but I prefer his company to the IRS's. Some of my 2015 fun has been restructuring businesses so that things are compartmentalized. It has allowed me to reduce earned income and make profit sharing distributions (no payroll tax) while contributing to tax-advantaged accounts (multiple 401k's, very generous company matching).

I'm in a different line of business (not real estate) so my situation is likely different. But in my case, it made sense to move assets into a couple of new corporate entities...the complexity and paperwork requirements are about the same, but personal filings are greatly simplified. And it gives me a lot of flexibility with wages and taxes.

In your case, with real estate, I would assume you would just keep rolling gains via 1031 exchanges. Rents are offset by expenses, but the business (hopefully) kicks off some cash flow. No matter how you structure it, that cash flow is income so income taxes need to be paid on it. You could do that personally (income tax), or put things in a corp (income tax) and kick off excess as dividends (more tax). But there is no magic bullet. In a corp, you might have higher expenses (including paying yourself: W2 wages as an employee, benefits, company 401k match, profit sharing, etc) but there is that pesky double-taxation. But you're dealing with two taxable entities, so you have more (twice?) the wiggle room for tax maneuvering.

Maybe we should collect up a few more people and start the MMM REIT.

[mr_orange]

Yes....I think our entity structuring is pretty efficient.  The trouble is that it is hard to structure entities for all situations.  We're planning to run the business full time at some point so the long-term entity structuring and planning really needs to revolve around that.  For now with W2 jobs and a business there doesn't seem to be a good way to get income characterized as earned income without paying more in FICA (including ACA riders) taxes. 

I am pretty well capped out on strategies to reduce taxes through retirement plan contributions, HSAs, etc.  The trouble with these types of plans though is that I can't self-direct them AND give them a labor component ("sweat equity") to juice the returns more.  Thus I am stuck with the choice of participating passively with tax-advantaged accounts or forgoing tax-advantaged accounts and participating actively.  The latter activity generates returns far in excess of the former one, but also requires work.  Balancing the two is very hard to do. 

Next year I have the fortunate situation of being able to fund pretty much all of the tax-advantaged accounts AND have cash left over to fund active activities as well.  If I keep the cash and avoid deploying it immediately it will allow me to live on the cash and structure new non-tax-advantaged projects (active ones) such that the taxes I pay are long-term capital gains and NOT ordinary income.  It seems that only certain types of projects will work for this though.  Lending on hard money projects probably won't work.  Development projects done repeatedly won't work either because our intent is to sell.  Something more like a commercial building we later lease or an apartment reposition may work better, but I want to avoid having the tax tail wag the dog. 

In general it may not be worth it to structure a new fund to avail ourselves of carried interest given the overhead cost.  It may just be better to do a JV or LLC structure with a promote and pretty much accomplish the same thing in one or a handful of longer-term projects. 

[branman42]

The trouble with these types of plans though is that I can't self-direct them AND give them a labor component ("sweat equity") to juice the returns more. 

Can't you deposit money into Solo 401k's and the like, then roll it over to a self-directed IRA and use sweat equity? I.E. investing in an LLC you create.

[mr_orange]

Yes, but doing so will generate FICA taxes in excess of the federal tax savings I get given my tax situation.  The SoloK doesn't help me unfortunately. 

[DaveR]

I've been thinking about this way too much the last couple of days...I lost sleep over it. Not your particular situation, but optimized long-term tax strategies. I'm tweaking my model, running simulations and seeing how sensitive things are to OI vs CG choices (er, requirements). I think your 7% difference/penalty is reasonable, though perhaps does not fully account for the ability to exchange assets/carry interest and defer CG.

In general it may not be worth it to structure a new fund to avail ourselves of carried interest given the overhead cost.  It may just be better to do a JV or LLC structure with a promote and pretty much accomplish the same thing in one or a handful of longer-term projects.

It should be easy enough to compute if it's worth it: if there is $100k of income/gains, then that 7% difference is $7k. If overhead cost is less than $7k, then it's worth it, right?

I don't know the mechanics of a JV + promote, but if it accomplishes the same thing with less overhead or more flexibility in project selection then that seems like a viable alternative.

[mr_orange]

Setting up a fund not only has the setup costs, but to do it right and grow it well you need audited financial statements and other overhead.  It really turns things into a business discussion at that point.  Unfortunately I don't think there is a good way to do this for hard money loans given the nature of the profits.  Doing a fund that repositions commercial projects or buys interests in companies is a different story though.  Given all of everything else we have going on setting up a new fund construct is undesirable.  It would just be too much work. 

I am going to dig in more on the JV construct for a promote.  We already do these, but they're for development projects where the intent is clearly to sell the property.  If the intent is to hold for investment it seems like a far easier way to convert OI to LTCG.  This is a material consideration for anything we do going forward because there are only so many hours in the day to spend contributing sweat equity to projects.  Contributing sweat equity to projects that can be treated as LTCG is quite a bit more efficient than contributing the same effort to projects where it will be treated as OI.  This all needs to be factored into the decision of which projects to do going forward. 

If you build a model with some data I'd love to see it. 

[DaveR]

I wouldn't think fund overhead would be a one-time setup, but rather a series of cash flows. Sounds like an IRR calculation...
But with "everything else...going on" the rate is probably irrelevant.

I'm sure there is a way to set things up such that "sweat equity" is converted into actual equity...happens all the time in the start-up world: stock options, restricted stock, and warrants. The kicker with all of those is you need a C corp, so double taxation and other fun tax headaches. I'm sure there are good reasons such structures don't happen in the real estate world as frequently.

The model I'm playing with is big and overly complicated (75 year monte carlo simulation). Plus it's in R (not Excel). If I can get it stabilized for this scenario, I might do a quick rebuild in Excel. I'm still turning a lot of knobs, so it blows up quite a bit.

[mr_orange]

Any luck with the model DaveR?

[DaveR]

I got distracted eating pumpkin pie.

The issues in my model at this point are around interest rates and bond pricing (ripping off a bunch of insurance actuary stuff). It doesn't really apply to this topic. So... I can do a quick and dirty version in Excel, but already know at a high level what it will show:

Assumptions:
we're talkin' enough income that the special rates in lower tax brackets don't apply
22% effective personal tax rate
15% long-term capital gains rate
33% corporate tax rate
No state income tax in TX

Total tax rates:

• 47.8% - as dividends (33% corporate, 22% income)
• 43.0% - as equity growth (33% corporate, 15% cap gains)
• 33.9% - as Earned Income (15.3% self-employment (FICA), 22% income)
• 22.0% - as Ordinary Income (22% income)
• 15.0% - as capital gains

C-Corps have the most flexibility for retained earnings, equity growth, stock options, warrants, and all kinds of other fancy stuff. But, they also have to deal with double-taxation, so pretty much any way you work it, it will cost more in taxes to get net dollars into your pocket.

After poking around, carried interest in partnerships (real estate promotes, private equity, hedge funds, etc.) are just a way to bypass the C-Corp double taxation (and corp treatment of cap gains as OI) to get more cash in your pocket.

I can build out a spreadsheet that shows all this, but I think you might already have a good handle on it all.

[mr_orange]

Thanks!

Yes, I wasn't really ever considering doing a C-Corp because of the double taxation issue.  We have a small venture company that we arranged as a LLC for this very reason. 

One thing that may be missing above is the small ACA taxation rider after $250k that will push the FICA taxes higher. 

In general I think looking for sweat equity activity that can be taxed as capital gains using a promote in the project is probably the easiest solution if I want the tax tail to wag the dog.  This needs to be balanced with finding projects that maximize after-tax income instead of minimizing taxes, but I think we can probably do both with some larger commercial projects.  There is generally a tradeoff in my experience, but I am trying to shift a bit from doing too much work to making my money work more for me.  So if I can get some ancillary tax benefits from it that would be a nice bonus.

[DaveR]

There are a number of little tax adjustments that move rates a few points one way or the other. None of them are as consequential as c-corp double taxation or the earned income differential. Avoid those two, and you are dealing with OI vs CG.

And we might be thinking way too hard about it.

Let's say you make a $300k investment that returns $45k (15%) in 12 months. No matter the structure, you don't pay taxes on the $300k, only the $45k of returns:
Passive option would be OI @22%: $9900
Active option would be CG @15%: $6750

Let's say that the sweat you put in to earn your equity in the active option was one Saturday (8hr) a month for 12 months. Those 96hr of sweat gave you a $3150 tax break. Yeah! $32.81 per hour...I'd rather have my Saturdays.

[mr_orange]

I agree that we're probably thinking about it too hard.  The tough part for me to know or measure well is what my OI rate will be annually.  The tax maze is so complicated for my situation and the income moves around so much at the end of the year it is hard to plan well.  Something in the range of 20-30% (probably closer to 20%) is probably right for our effective rate. 

LTCG should be fixed at 15%, but I read some stuff claiming that it is higher if we make more:

http://www.marketwatch.com/story/capital-gains-at-what-rate-will-your-long-term-sales-be-taxed-2015-02-18

In any event converting activities from active where they'd be taxed at OI to "passive" (investment + sweat equity) surely will reduce our tax rates around 5% or more.  You would have to make a bunch of income assumptions it seems to know how much it would help and it may not be worth letting the tax tail wag the dog given the difference in rates. 

What I'm struggling with is how much cash to keep on hand given that converting income from OI to LTCG is going to require more cash most likely.  We'd need to be able to take the income in big lumps as opposed to it being in smaller chunks periodically. 

[DaveR]

Interesting article. The rates vary, but net result is CG is going to be a few points less tax no matter your tax bracket. Make a boatload, you'll pay at a higher rate, but CG is always better than OI.

But... cash.

Optimal strategy is to have just enough cash to cover expenses. You replenish the cash reserves from the periodic lump sums.

For example...
You have $200k in cash
$5000 monthly expenses
$4000 OI from rentals (net of taxes)

You have a JV op that will liquidate in 24months, so:
set aside $1000*24 = $24k for expenses (in something safe and boring like TIPS)
put $176k into the JV
sleep soundly at night

You're playing with liquidity risk. The big unknown is if that JV will cash out on schedule. If it takes 36mo you might have some problems. You'll need buffers or contingency funds or credit lines to manage that risk. And theoretically, the 5 or 7% tax advantage offsets (most? all?) the interest you would pay on a line.

[mr_orange]

Yup....I have credit lines right now for our business. 

The rub is that we have to maintain certain levels of liquidity to keep a big credit facility we're working on closing.  Next year we'll have a $3M line of credit for our projects and need to keep 5% "compensating balances" with the lender for the covenants.  So that's $150k, but it can be split with my partner.  I then need cash to cover rental capex replacements and some buffer to sleep at night.  The sleep at night buffer needs to be traded off against the need to covert LTCG to OI and thus pay higher taxes.  I know I need more cash in general, but we don't want to keep too much or rely strictly on lines that can be called to harmonize the entire strategy.