Double Trouble for Your Wealth: Rules and Regulations
Rules are meant to keep things rolling smoothly, but if you don't understand them or decide to try to steer around them, you could be headed for big trouble. And the wealthier you are, the higher the stakes.
Wealth creation and attaining your desired lifestyle are cornerstones of the American dream. While wealth brings clear luxuries, the harsh reality is that with greater wealth comes greater risk. New challenges emerge with affluence, and these obstacles often threaten the stability that you’ve worked hard to achieve.
As your wealth grows, it is critical to install and periodically update your asset protection strategy. Both external and internal threats exist, and they cannot be ignored. Without proper preparation, your wealth can disappear faster than the time it took to accumulate it.
In this three-part series, we are exploring the main threats to your wealth, categorized as the three R’s: relationships, rules and revenues. In the first article, we examined the mismanagement of relationships. This article will dive into rules and how complete awareness of legislation can safeguard you from potential threats.
Rules and regulations are a foundational component to modern society. However, these rules and standards can cost you if you find yourself on the wrong side of them. The wealthier you grow; the more important understanding legislation becomes. Fortunes have been lost and wealth has been squandered simply due to a lack of awareness and disregard for the law.
'The Doorstep to the Temple of Wisdom is a Knowledge of Our Own Ignorance'
One of the most manageable but costly risks is a simple misunderstanding or disregard of the tax system. I’m not suggesting that everyone needs to be a registered tax attorney to grow and maintain their wealth: Employing one, on the other hand, might be something to consider!
For example, having a clear understanding how your income is changing from year to year can help to ensure you are making accurate estimated tax payments. We often see people making misguided assumptions about their tax liabilities, resulting in excessive payments that put pressure on your cash flow as well as missed earnings potential. Simply put, by being proactive and regularly scheduling your tax-strategy meetings well in advance of deadlines, any life changes, legislation changes or year’s end, you give yourself an opportunity to maximize your after-tax returns. These tax-strategy meetings can occur as often as quarterly. Savvy stewards of wealth develop and maintain nimble balance sheets that carefully consider where their returns originate from and the tax treatment of those returns. If something can work more efficiently, changes can be made without deviating from your long-term goal.
Also, in regard to taxes, keep in mind that audit risk is prevalent among the wealthy. According to Time magazine, the most likely candidates for IRS audits are individuals who report more than $10 million in income, who file estate tax returns for assets worth more than $5 million and who file international returns. Additionally, in 2015, earners who brought a home valued at $1 million or more faced a 9.55% chance of an IRS audit, compared to a 7.5% chance in 2014. If you find yourself in this income bracket, it is advisable to work with a tax professional or business manager to maintain strict records of cash flows. Should an audit take place, maneuvering through the process should, in theory, be painless.
“IRS” is a trigger word for some, and most people are either fearful of the agency and tend to overpay or are too aggressive and find themselves with unpaid taxes. Ignorance is not excused by the IRS, but proactivity and preparation can help prevent manageable issues from becoming larger problems.
Dilemmas and Disputes
With 80% of the lawyers in the world living in the United States, it comes as no surprise that the U.S. has the highest rate of lawsuits. Individuals and families that have amassed large pools of capital have become increasing targets for lawsuits over time.
Many people are not aware of the different protections (or lack thereof) that exist for key assets in different states. Although all 50 states are governed by the same executive legislature, governance at the state level could be the difference between assets and liabilities on a balance sheet.
For example, if you and your family own a primary home worth $1 million with no mortgage, and you were sued in California, only $75,000 of equity is protected by the state. The remaining $925,000 is at risk of being used to fulfill a court ruling. However, if you own this same primary home in Texas instead of California, 100% of the home is protected by the state, and $0 of equity could be used in a court judgment. This type of awareness is a concept that will serve to protect your wealth in all forms, and decisions like where you live should not be arbitrary.
Asset Protection and Minimizing the Risk of Doing Business
Self-made individuals often take abnormal risk when generating their wealth. However, after a certain point, they must start carefully considering how they make investment decisions moving forward. As such, asset-protection strategies have become a common tool. For example, it can be advisable to hold assets in the name of a separate entity, such as an LLC. Most commonly we see this with rental properties.
It is important to note, affluent households are often viewed as businesses, in that they need to be thoughtful of how they are holding their assets. The process of asset protection involves assessing the risks of your current situation, identifying future goals, and designing a risk management strategy to most effectively accomplish these goals.
Two questions to ask yourself before making a sizable investment are 1) what is the purpose of the investment, and 2) what are the associated risks? In keeping with the rental property example, the purpose of the investment is to generate passive income to supplement portfolio returns. The risks associated with the investment in this case are typically manageable, in the form of lawsuits that arise from property use. In order to protect your personal assets, holding the property in an LLC can protect you, in case of litigation.
Don’t Stay in the Dark
Awareness of rules and regulations is pivotal to the preservation of your wealth. Preparation prior to making a financial decision is a foundational principle of creating and preserving wealth. By employing responsible fiduciaries on your advisory team, thoughtful planning and consideration can be the difference between well-guarded financial success or litigation.
About the Author
Josh Sailar, CFP®, CPFA
Investment Adviser, Miracle Mile Advisors
Josh Sailar is an investment adviser at Miracle Mile Advisors, an independent registered investment adviser in Los Angeles. He specializes in constructing and managing customized advanced plans for business owners, executives and high net worth individuals.