Catch the full episode: https://www.wealthformula.com/podcast/286-ninja-tax-strategies-with-tom-wheelwright/
Buck: Welcome back to the show everyone. If you missed the most recent Wealth Formula meetup in Dallas, there was a moment of kind of surprise for everyone, including me, as Tom Wheelwright went up there and came up with a new paradigm, which at least a new paradigm to us. And it sounds like it was something of a revelation in a recent meeting with Doug. But I wanted to get Tom back on the show to discuss this today. Tom, thanks for coming back on Wealth Formula podcast.
Tom: Always good to be with you, Buck. Always good.
Buck: Okay, so tell me the truth. This whole concept. I know you flew in with Doug Lodmell. He flew in. Right. So Doug is a pilot and you were flying and did this idea just kind of come together on that flight with Doug at the wheel, because I have this vision of Doug, like flying in with you.
Tom: I will say we have some great conversations, but no, this is actually a strategy that we’ve been using for years and years. I’ve used it myself. And the question, it’s always that big question, right. Which is okay, if I can’t be a real estate professional, how do I use my real estate losses? That’s a fundamental question. And as a general rule, it’s pretty simple. Can I draw?
Buck: Yeah, you can draw. And remember, a lot of people are going to be listening to this.
Tom: I’ll describe what I’m drawing
Buck: And just to be clear for everyone. I’m sure that most people on the show have not heard of this concept because I hadn’t really used the various trusts and things. But it’s an idea that essentially allows you, as Tom said, to use passive losses for somebody who’s not a real estate professional, and also provides estate planning. And we can talk a little bit later about the implications or why that’s important right now and then asset protection, all in one.
Tom: So the asset part is the part we talked about on the plane because that’s an important part of this. And Doug was not familiar with this income tax strategy. So I was sharing the income tax strategy. The general rule, of course, is that rental real estate losses are passive. Right. And the rule for passive is that passive activity losses can only offset passive activity income. We call this passive activity income. That’s coming from a pig, a passive income generator. So we always say pigs are our pals. Okay. So the question is a lot of people can’t be real estate professionals. I mean, you’re a real estate professional for you, Buck, this would make no sense. That makes no sense at all. Which is why you haven’t heard of it, right. But for those of us, like my wife and I were both full time in our business, we’re not going to be real estate professionals. All right. Well, then, remember, passive loss can only offset passive income. This does not say this is not passive losses are not deductible. And that’s the mistake people make. And that’s the mistake tax advisors make. They tell their clients. Well, it’s a passive loss. So therefore, it’s not deductible. That is patently false. Okay. Passive losses are absolutely deductible. They’re just only deductible against passive income. Right. So the question is, if I can’t make my passive losses active, how do I make my active income passive, right? That’s it. That’s the entire question. So it’s really simple. And it’s a simple matter of ownership. What I’m going to drop here for those of you who are watching or listening is when we set up ownership of real estate and ownership of businesses, we tend to make them two separate groups. Okay. So we have one group where we have the taxpayer and they own their business. Let’s say it’s an S Corporation here. And then we have another group where the taxpayer owns real estate. They typically own it through a holding company. If it’s not a syndication, if it is a syndication, they just own a bunch of syndications. All right. So the challenge we have is that the real estate is passive. But because you’re active in your business, your business is active. So now we have a mismatch. What we’re trying to do is create a match passive income, passive loss. So what do we do? We use a trust. This is where the trust comes in, and it’s a trust for your children or your parents. It could be your parents, but certainly could be for your children. And that’s usually what we do because most people want to pass on their estate to their kids. And so this only works, by the way, if your children will eventually inherit your assets. If you don’t want your children to inherit your assets, don’t do this because this is an irrevocable trust. Irrevocable means it cannot be eliminated. There are some changes we can make in it, and that’s Doug’s purview, but we cannot eliminate it. Once we put the asset in there, it’s owned by that trust. Okay. So this is a children’s trust. Typically, you do a trust for each child or you do one trust that benefited each child. All right. Now, let’s say that this trust owns some of your business and it owns some of your real estate. Well, if your children aren’t participating in the business that effectively converts that income from active to passive, because to your children, it’s passive. Now, there’s a very important point here.
Buck: But just to review now, we’re saying I just want to make sure we go through this incrementally from the business. It can be any kind of business. Could it be a business that invests in real estate? Could it be that’s not a business?
Tom: That’s an investment. So we have real estate investments, and we separate them out because they’re the ones that are passive to begin with. But now we have a business that is an active trader business. It could be in many States, it could be a doctor’s practice. So it’s only a business where the state law allows a non professional to own the business. So, for example, in some States, a medical practice can only be owned by physicians. In other States, medical practice can be owned. At least a minority interest can be owned by anybody. Right. So that’s a critical point there, Buck.
Buck: Yeah. Well, and then the other thing, just because there are a lot of physicians in a lot of States, there are laws that prohibit you from non physicians owning I mean, one other potential circumvention. There is there’s a lot of medical practices owned by these MSOs, right. So the management service organizations that stuck off a significant amount of profit
Tom: And the MSO’s typically can be owned by non physicians.
Buck: Exactly. Right.
Tom: Or they may be, for example, maybe a hospital, like a surgical center, something like that. Those typically can be owned by non physicians as well. It’s really just the medical practices, typically that are restricted. It’s not the other health services that are restricted. Right. So the goal here is, again, for a non active person to own the asset. Now, there are some very specific technical restrictions here. Typically, your business is going to be an S Corporation. Well, a typical trust cannot own an S Corporation that will blow your S election. So you can’t do that. What we do instead is we make this a defective trust. We call it a V debt beneficiary defective income trust. Okay. If you have a revocable trust, let’s say you have a family trust. That’s a revocable trust. That’s a grantor trust, meaning that you are taxed on that. Even though it’s in the trust, the trust doesn’t pay the tax. You do. Most people have a revocable trust. Okay. Everybody should. What a beneficiary defective trust is rather than you being taxed on it as the grantor, the beneficiaries are taxed on it. And the reason is because they have some kind of power. All right. And this is all technical stuff you’ve got to go through with your CPA. Your attorney, make sure that all the technical details are handled. I’m giving this to you from a very conceptual basis. So what you have is now on your child’s tax return. They’re going to show income from the business and loss from the real estate, and they’re going to offset
Buck: Exactly so the bottom line is, and the key point here, folks, is that because they’re not active in your business, they’re bringing passive income there, and that’s going into the BDIT. And then the passive losses from the real estate investments are going into the BDIT. And they’re basically offsetting one another. Correct. Right now. So from the trust perspective you think about. Okay, this is a non grantor trust. What would it be? Non granted trust. How would trust like that be taxed?
Tom: This is a grantor trust. It’s just not taxed to the grantor. It’s taxed to the beneficiary. It’s still considered a grantor trust. In other words, it’s a flow through entity like your S Corporation is flow through to you and you get a tax Corporation. A beat. It is a flow through entity, and the beneficiaries pay the tax. The trust does not pay the tax. So whatever your beneficiary’s tax rate is, that’s the tax rate they’re going to pay. So of course, if they’re minor children, then they’re paying your rate anyway. But the goal is to have the income offset by the losses from the real estate, so they’re not going to have any income. They’re not having a net income flow through this trust. Typically, those losses from the real estate are going to offset the income from the business. They’re going to have some mismatch in some years, and you may have a little bit of income and then it’s taxed or whatever the child’s tax rate is.
Buck: Got it. And in this scenario, would that BDIT, would you be functioning through the BDIT itself or a holding company that’s owned by the BDIT?
Tom: Well, no, the BDIT has to own the S Corporation directly because you can’t have a holding company on an S Corporation. All right. Right. It has to be directly owned by the effectively owned by the Beneficiaries. It has to be owned by individuals. Corporations have to be owned by individuals. They can be on it through a grant or trust, but it has to be owned by individuals. We do have a holding company on the real estate, right. This is a holding company now the real estate. Of course, you’re going to be the managing member of both the S Corporation and the holding company for the real estate. So you’re going to have control. These are going to be non voting shares. And this is going to be a non voting interest in the limited partnership or the LLC that is the holding company for the real estate. So you’re still maintaining all the control. Just know, though, that asset for state tax purposes, it is not yours. It belongs to the trust, which eventually, depending on how the trust is worded, is going to belong to the kids. And that’s a big key. The other big key here, buck and I’ve seen people get in trouble with this, which is why I don’t normally talk about this on a stage or in a recording like this. So we’ll keep this to just your people, please, is that people can get in trouble with their kids. Okay. Let’s say now you may have conversations with your kids all the time about finances and where you are financially and all that kind of stuff. I do. I’m very open with my sons about it. They know all about this. My sons are very much aware. I go through this all the time with them. So they’re aware of what’s going on. And I go through their tax return. But remember, this income is going to end up on their tax return. And I’ve actually seen kids have problems with spouses and other problems because the spouse may think, Well, you’re a trust fund, baby. I don’t need to work. And there are personal issues that come up. Remember, it’s going to be reported on their tax return. So it’s a limited application to those people that are comfortable that their children know how much income they make from their S corporations, because your kids are going to know your kids are going to know what you have from a real estate standpoint, from a parent financial education standpoint. I think it’s awesome because real life, you’re actually training your kids. You’re telling them and you basically say, look, this is what you’re going to have when I die, you’re going to get nothing until I die because you have control over it.
Buck: Yeah. And that’s an important point because I think a lot of people think of these irrevocable trust and say, oh, I’m giving all this. I’m not ready to give this way. You’re in control. You’re completely in control. The only time that we’re really talking about a functional change in, like, whose money it is at the time of your death, which is what you want in the first place. If presumably, if you wanted to do this kind of set up. Tom, one question for you that I think I’m curious about is one of the things that came up during the meeting. I think you talked about it. I talked about a little bit. Was the legislation with regard to granted trust, like, for example, a Nevada dynasty trust or whatever. The idea with those kinds of trust in the past has been that you can effectively again have control, but your kids own the trust. And so it’s a very similar concept to that. But the reason I got confused on the grantor element here is because those are granted trust. And what that means is that for me, for example, if I have a granted trust, which I do, I pay taxes on the money that comes in there. But the advantage is I pay taxes on it, but it’s out of my estate. So for me, it’s a planning thing where I and many other people look at it as a way to potentially circumvent the estate exemption, right?
Tom: It’s a loophole. It’s an absolute legal loophole. There’s no question. It’s legal. It’s been tried in courts. The courts have been very clear that income tax that you pay is not subject to a state tax, not subject to gift tax. So it’s a way to get more out of your estate with the grantor trust. What’s being proposed in the new legislation is that whoever gets taxed on the income is in their estate. So, like here’s, grantor trust if you set up a grantor trust, but it was just a defective trust, meaning that for estate tax purposes, it’s taxed to your kids. Right. But for income tax purposes, it’s taxed to you that’s now going to be included in your estate. If this proposed legislation goes through with the BDC, we don’t care because they’re being taxed anyway. So it’s going to be included in their estate. They have the income, it’s going to be included in their state. We want it to be included in their state. So that proposal, the way it’s written right now, does not affect this planning idea.
Buck: In summary, here, though, the value of this is significant, and unfortunately, it’s really not going to help anybody who’s still flat out W two you still got to have if you can figure out how to if you’re a physician, if you can figure out how to become an independent contractor, an LLC, then have the maybe there’s ways to do it. Who knows? Right. But is it W two, you can’t do anything like this. But that being said, if you can do this, you just saw you’re effectively changing active and capacitive income. The asset protection is there because you’re not the owner, right? Right now, I guess your asset protection. What about the kids’ liability, though?
Tom: No, you set it up as a trust. So for them, they only have a couple of one or two minor powers. They do not have the power to take money out of the trust. That is not one of their powers. So if somebody sues them, then it’s in the trust. Okay. Somebody sues them. They don’t get it.
Buck: And then finally, we just discussed, of course, the estate planning element. So that is a very powerful vehicle. Now there are some people, including myself, who are real estate professionals. And like you said, what would be the point of this is no real point, except for one. Now, which is that for people who do have an estate exemption problem. If the legislation actually goes through and you can’t have the grand trust flowing to you and get things out of your estate, you’ve got to figure out a different way to do it. And in that situation, it seems like that could be sort of potentially a downside to their real estate professional status. In other words, if you are so successful that you’re going to pass that exemption, well, then what have you thought about that?
Tom: Absolutely. This actually makes this plan even more important, because what it means is under the new proposed rules under the proposed legislation, a complex trust. This is one where the kids aren’t taxed, where the trust itself is taxed. That’s a complex trust that’s going to hit the highest tax rate of 39.6% at $100,000. So it’s not going to be 500,000. $600,000. It’s going to be $100,000. So that’s a big deal. That’s a big difference. Sure. I prefer not having a tax as a complex trust. Now, if your losses offset your income doesn’t matter. You can be a complex trust. The only problem is a complex trust can’t be a member of an S Corporation under the S Corporation rules. Okay, so only an individual or certain types of trust pass through trust can own an interest in an S Corporation. So if your business is in an S Corporation, then you have a different challenge, right? Because it’s a business and S Corporation. Really, your only way to do it is either for it to be a grantor trust tax back to you, which now under the new rules that bring it into your state or a beneficiary defective trust, which would get it out of your state and would avoid that high tax rate at $100,000.
Buck: But I guess maybe I’m missing it. You might have said it might have gone over my head for a real estate professional who is trying to use the benefits of the rep status with losses, but yet needs to really focus on the estate element of this, too. What is that structure?
Tom: There’s going to be a couple of options. One is, and this is a Doug question. Okay. Which is, could you be the trustee? Because if you’re the trustee and you’re the real estate professional, now you get that real estate professional. But here’s the thing. It doesn’t matter as long as my point for you, Buck, is it doesn’t matter. Let’s say that you’ve got some losses that offset your real estate professional, and you have some losses here because you own some of this and it offsets the income from your business. Great. No worries. But let’s say you also have some that you want in the trust because you want out of your estate. Great. Then it offsets because it’s passive. I don’t see your downside.
Buck: Can you have both? I mean, a real estate professional can’t claim any of their real estate losses as passive, though, right.
Tom: Why do you need to? You don’t need to because your real estate losses
Buck: No, I get that. But what about the estate issue?
Tom: I understand. But again, as long as look, any assets you transfer into the trust, they’re going to offset because they’re passive passive, right? Yeah. Any assets you keep, they’re going to offset because they’re active. Active. But the question is, how much do you want to put into the trust? How much do you want out of your estate? That’s the question now becomes a pure estate planning issue because you’ve completely avoided the tax planning issue, right? Yeah.
Buck: Well, this is fascinating and certainly something that I think a lot of people are going to have to. Who knows about this tax legislation? Ryan is still legislation. We had this discussion in Dallas we talked about. Obviously, the granted trust issue is a legal loophole, as you’ve discussed. But on the other hand, one of the reasons why people refer to the estate tax sometimes as the stupid tax is really that’s all it took, right? It’s just getting one of these grantor trust and boom, you’re out. And if you didn’t do that, you were just stupid. So that’s why they call it a stupid tax. But one thing that makes me wonder about it is it’s not like that stupid tax or this issue hasn’t been obvious for years and years and years. But there’s one thing that potentially could benefit it is that it probably billionaires everywhere using this. And there’s a huge amount of political clout. So that’s the other side of this, even though it’s a legal tax loophole, maybe it doesn’t end up because of that. But if it does, I mean, this is going to become very commonplace. And you need somebody who can tell you how to do this, like, Doug and Tom, tell us a little bit about WealthAbility. You guys remind us about WealthAbility and how we can get in touch.
Tom: So WealthAbility, we are fundamentally education, okay. Is what we are just like you are buck. Well, formulas, fundamentally education. We’re fundamentally an education company. We educate both investors and business owners and CPAs, and we bring them together. So we vet CPAs. We have almost 50 around the country now CPA firms, and we vet them, and we train them and we put them through our process. So we developed a process. This is part of the process. We do this. We do this regularly, the reason you don’t know about Bucks, because until now, it hasn’t made any sense for you. So there’s been no reason for you to know. And I don’t like to clutter your mind with stuff. I have to let something out before I can let something in.
Buck: Well, I’m always cluttering your mind with constantly pushing.
Tom: By the way, it’s always somebody in real estate, the real estate people that push. And I like it. Actually, I love it. I love it because it does push and it makes you think so. WealthAbility. What we do is when people talk to us about, well, I need a CPA firm who can do this kind of stuff. All right. Well, the only CPA firms I know that can do this type of stuff are WealthAbility CPA firms that are part of the WealthAbility network because we train them how to do this. I will tell you most WealthAbility CPA firms that come to us have never heard of this either. I don’t know why. And I don’t know why. This is a big mystery to me. This is so obvious. The only time you lose the passive nature is when it’s a spouse. So you can’t transfer this to a spouse and say, you’re going to get passive, but you can to a child. There’s no attribution to a child. There’s only attribution between spouses when it comes to active participation in a business. So what we do with our wealth value members is like we have a three day training coming up in November. We’re going to train them on the new law, but we’re not going to train them on the technical aspects of the new law. We’re going to train them on. Okay. Now, what kind of planning do we need to do now that the law has changed? So we’re all about planning, and it’s all about how to build tax free wealth and how to cater it to each individual person. But more importantly, it’s the system like your formula. There is a formula for reducing your taxes. There is a formula for building wealth, and we use the same formula all the way through. Individual facts may differ, but the formula stays the same. And so we want to make sure everybody gets the maximum benefit from their relationship with Ability advisors. And by the way, easy way to contact us is wealthability.com.
Buck: I would also suggest that when you do that, make sure you tell them that you’re a Wealth Formula community person, because it really does make a difference. Our people are a little bit coming in with a little higher level of sophistication. It does help to give the heads up to the people, so they know who they’re kind of dealing with.
Tom: There’s no question Buck. Understanding how to do this. As a taxpayer, you’ve got to participate in your tax planning. Somebody with the background coming from you, Buck, we find them to be much more educated, much more sophisticated. They tend to ask better questions. And we love Wealth Formula members.
Buck: And along that lines, guys, it’s really important that nothing’s perfect. Nobody’s perfect. And so if it’s not a good fit your first time around, let us know. He’s Tom Wheelwright. He’s again, Michael Jordan of Taxes here. But on the other hand, he’s very interested in seeing you succeed and us succeed. So if you for some reason get placed with somebody and you don’t have a good fit, just let me know, let Tom know and get you a new fit, right?
Tom: Absolutely. We do our best to get that fit, right. But we don’t know that much about you. So every once in a while, somebody goes, you know what? I need a different fit. We’ve had actually a couple of those in the last year, and we’re just going to give you the better fit. That’s all we’re going to do. That’s why we have 50 members, right? It’s not one size fits all.
Buck: Totally. Well, Tom, thanks for coming back on Wealth Formula Podcast, this is really good stuff. Obviously, my head is turning here and figuring out how this is going to work for me. But one last question for you, though, when are we going to know or do you think we’re going to know about what ends up being law versus what is not?
Tom: So here’s where it is. It’s still at the House and it’s not even gone to the Senate yet. Nancy Pelosi says there’s going to be a vote by the end of October in the House. Okay. That means that they’re going to pass something in the House. Then it has to go to the Senate. The Senate has to figure out what they’re going to pass, and then they have to reconcile the two. So my guess is probably mid to late November is when we’re going to get a new bill.
Buck: Senate is still under Republican rule
Tom: sort of sort of it’s really 50-50 at the edge there with Vice President Harris. But they have to have all 50 so they can’t have one even one person defect. Kyrsten Sinema from Arizona, my home state, and Joe Manchin from West Virginia are holding the line on keeping the size of this bill much smaller. And so they’re definitely having an impact.
Buck: Fantastic. Tom, thanks again. And obviously we will continue to get updates from you. Keep up the good work, keep up the fight. And thanks for coming on.
Tom: All right. Thank you.
Buck: We’ll be right back.