010 | Level 3 Tax Planning: Secrets to Tax Optimization and How to be Compliant with the IRS

Considering advanced tax planning but unsure about the benefits and pitfalls? We’ve got the answers you need.

In this episode, host Patrick Lonergan, navigates the complexities of Level 3 tax strategies, where creativity meets a fair amount of risk. While these strategies undergo close scrutiny from the IRS, we provide insights into how the right approach can ensure compliance and unlock substantial benefits. We take a look into taxes from the government’s perspective, offering a deeper understanding of compliancy, and pack the episode with real-world examples and essential considerations for a proper setup. 

Join us, as we explore Level 3 Tax Planning, providing a roadmap for tax optimization while staying compliant with the IRS. Whether you’re a seasoned entrepreneur or an individual looking to enhance your financial tactics, this discussion is packed with actionable strategies that can transform your approach to tax planning.

Key Takeaways:

  • Unpacking Level 3 Strategies
  • IRS Compliance Insights
  • Benefits vs. Risks


2024 Planning Resources

Read the Transcript

Submit questions to the podcast


Sponsored by Vital Wealth

Music by Cephas

Produced by BrightBell Creative

Research and copywriting by Victoria O’Brien

Welcome back to the Vital Strategies Podcast. I’m your host, Patrick Lonergan. And today we’re going to look deep into level 3 tax strategies and how they can help create tremendous deductions to help you build wealth and also stay on the good side with the IRS. Level 3 tax planning is where the creativity comes into play, but also a fair amount of risk.

Make sure you listen to the end to understand how the tax code works, how to avoid trouble with the IRS, and hear about a couple of examples of level 3 tax strategy in action.

Let’s review the levels of tax planning. Level 1 is the IRS gives us guidance and it doesn’t take any investment. This is good administration and bookkeeping.

Level 2 is the IRS gives us guidance, but we have to invest dollars to get the deduction. 401k plan or cash balance plan like we discussed with Bruce Gendein in episode 6.
Level 3 tax planning is, the IRS permits the strategy, but doesn’t like them because they’re often abused. If you execute on level three tax strategy, you have to make sure that you’re using a third party administrator that has an excellent track record, and all of your I’s are dotted and T’s are crossed, because the strategy is more likely to get scrutiny.

Level 4 tax strategy is tax fraud. The reason we bring this up is because there are people out there pitching ideas like they’re legitimate and they’re not. Also, you can abuse sections of the code and take a deduction that really wasn’t legitimate. A great example of this is putting your kids on payroll, but not actually having them involved in your business.

When we think about advanced tax strategies, you don’t want the IRS or Department of Justice knocking on your door wanting to have a conversation. Let’s step back for a second and really look at what the tax code is trying to accomplish. The first objective is to raise money for the government, but the second objective is to incentivize behavior.

There’s a sweet spot where if the government taxes too little, they leave money on the table. And if they tax too much, people stop producing and the government won’t collect as much income as they could have. If the government taxes an activity to excess, people will stop that activity. A good example of this is tax on cigarettes and tobacco.

They want people to use it less because it costs society in many ways. Healthcare and that type of thing all come into play. The easiest example of how the government could stop an activity would be if the tax rate on income was 100% on every dollar you earned. It’d be very likely that nobody would work.

So as the tax rate increases, the incentive to earn another dollar decreases. We have clients in high income tax states like California and New York who are paying a portion of their income at over 50% income tax rates. That is why these clients in these states are really excited about building a tax strategy that diverts income from the tax bill to wealth building.

The government effectively funds 50% or more of the strategy for them. Then we can start looking at other areas of the tax code and see how things like life insurance cash values and death benefits are tax free tools because the government figured out that it was in the public good to have people utilize life insurance versus end up in poverty with an untimely death.

We can also look at tax credits that incentivize behavior. There are things like low-income housing tax credits and tax credits used for revitalizing historic buildings. Oftentimes these projects would be economically unfeasible to develop. Unless there is a benefit from the tax credit. We can also see things like depreciation schedules on real estate.

Most of us are familiar with real estate that if it’s maintained, increases in value over time and does not decrease in value. But the government gives us tax benefit for owning real estate because they figured out that the private sector is much better at owning and operating these properties than the public sector.

We see how the accelerated depreciation from the Tax Cuts and Job Act helps spur on development because of the economics improved with these deals, because of the additional tax write offs. This is why we think real estate is a key pillar of wealth building. We can also look at things like qualified business income deduction that gives business owners a tax deduction for running a profitable business and having employees.

The government knows the value of putting people to work and having them earn money. It increases the tax base. So why not incentivize that behavior? So when we look at level 3 tax planning, typically what’s happening is people are combining sections of the tax code to construct a strategy that is very tax efficient.

Now I can say when the IRS sees an opportunity that’s only being utilized for tax reduction purposes, they don’t like it. They will quickly move to shut down the strategy. There needs to be a business purpose for the tax strategy. Again, it all goes back to incentives. If the only incentive is to pay less tax and not create public benefit, the IRS will find a way to shut down the strategy.

A great example of that recently was the abuse of conservation easements. People were buying land solely as a tax shelter, and these were all set up through different groups and they controlled every aspect of the transaction. After the purchase, it would be appraised for a significantly higher value, sometimes five, six, seven times the purchase price, and then donated to the public use through a conservation easement.

The way this worked out for high income tax earners in the 37% bracket was they spent $100,000, and then it appraised for $500,000 a short time later, and then was donated to the conservation easement. That would create $185,000 in income tax savings. There were companies putting these transactions together from start to finish and were charging huge fees and were abusing the system.

They were having appraisers inflate the value of the land and were controlling every aspect of the transaction in a way that was bypassing the intended purpose. Now, we’ve explored conservation easements with some of our clients for land they already owned and contributing it to the public use. And when done properly, it can be a great tool.

But it was from transactions like this, where the abuse was happening, that the IRS came with the Department of Justice and rated organizations that utilize these strategies. Now, that mess quickly included their clients. I know one advisor who put clients into these transactions, and also did them himself, and each person was paying upwards of $25,000 in legal fees just to defend themselves.

You do not want to be in this situation, fighting against the government with their nearly unlimited resources. What a legitimate Level 3 tax strategy looks like is combining strategies that utilize the tax code for real business purpose or to contribute to the public good. A couple examples that we consider level 3 tax strategies are Captive Insurance Companies and a strategy called a restricted property trust.

Now let’s take a look at how these things are put together. A Captive Insurance Company is utilizing the tax code that says insurance company premiums are not taxable as income to the insurance company. The insurance company can reinvest those premiums to help pay for claims that the company might be exposed to.

Now, they pay tax on the gains from those investments, but not the premium dollars. So, when we look at this strategy and think about how we can apply that to our business, there are third party administrators out there, some who are legitimate and do a great job, some who play fast and loose, and others who outright commit tax fraud.

We’re not willing to work with anybody that plays fast and loose or commits fraud. An example of this is a client shared with us an experience that during a meeting with a captive administrator. The administrator showed them a slide of money going into a washing machine and coming out clean of all income tax on the other side.

That would be an almost unbelievable thing to show a client. Again, if the only purpose of the strategy is to reduce income tax, the strategy is going to have problems. Now, what does work is when you set up an entity here in the United States, one of the administrators we work with uses North Carolina, another uses Delaware.

The insurance company is regulated by the State Department of Insurance. There are third party actuaries that aren’t associated with you or the administrator that price the coverages according to the industry standards based on the risk that’s taken. And these premiums are funded into the policy based on those third party numbers.

This is how a legitimate captive insurance company is set up. Now there is also some other metrics we need to look at, such as the percentage of premium to revenue. It’s hard to justify with a straight face to the IRS that it’s a good business decision to pay a third of all my revenue into an insurance premium.

If I’m only doing that to completely wipe out the profit from the business by putting it all into the insurance company, it’s going to be an issue with the IRS. Also, even if you fund it appropriately, but try to turn around and use that insurance company as your own personal checkbook, we’re going to have problems with tax fraud.

The insurance company can definitely make investments and things like stocks, bonds, ETFs, and they can also make loans for real estate opportunities. But it’s safe to say if you put the money into a strategy and get a tax deduction, there will be limitations with what you can do with that money. A great example of that is putting money into an IRA.

When I put money into a retirement account, I can’t draw the money out until I’m age 59 and a half. The government gives me a tax deduction. For an incentive to fund the account. So I’m not destitute in retirement and need to lean on public assistance to survive. To get the deduction, there are strings attached that don’t allow me to draw it out until I’m in retirement age.

One of the reasons Captive Insurance got a bad rap is because there were third party administrators setting up offshore entities, meaning not U.S. based entities. So there wasn’t a State Department of Insurance overseeing them. Business owners were using the funds like their personal checkbook. They would take a tax deduction and turn around and use those dollars for just about anything they wanted.

And they’d be putting huge premiums into their Captive Insurance Company, effectively paying no tax. This is why the IRS has captive insurance companies on the dirty dozen list. It’d be a foolish thing to try now to execute on one of these captives this way. We rarely see audits for the captives that we’re involved in.

When we do, because we work with reputable administrators, it’s not a problem. Remember, we shouldn’t be scared of an IRS audit if we’ve done everything by the book. An audit is really just someone coming to make sure that we’ve followed the rules and been compliant. If that’s all true, there’s nothing to be worried about.

With an audit, good bookkeeping, administration, and working with professional advisors can make audits relatively painless. Another strategy that is a Level 3 strategy is a Restricted Property Trust. This is an employer sponsored plan for owners and key executives. The annual contribution is fully tax deductible to the employer and partially taxable to the participant.

The tax treatment depends on two things, the provisions of the life insurance contract and the provisions of the trust. One of the key trust provisions is that the employer must make the selected annual contribution each year for the restricted period, which is a minimum of five years. Failure to make the annual contribution causes both the policy to lapse and the surrender proceeds to be given to a preselected charity.

This creates a critical risk of forfeiture, which means the owner doesn’t have constructive receipt of the property or control over the asset. If they do, then there is no tax deduction. Again, this strategy needs to have a qualified administrator set up and monitor the plan to make sure all of the rules and regulations are followed.

You will hear some people say you cannot deduct the premiums for a life insurance policy. This is just one of three strategies that we utilize that allows us to deduct the premium of the life insurance policy. So, when we think about other level 3 strategies. They’re doing exactly this: they’re taking areas of the tax code that were designed to incentivize behavior and combining them with others to get the most efficient outcome.

The challenge with this creativity is it may go beyond the scope of what the IRS intended. The problem with trying to defend a strategy in court is it can be very expensive. The government has effectively unlimited resources, so you have a choice of defending the strategy, possibly losing the case, and still having to pay the tax, penalty, and legal fees.

Or you can decide if the IRS challenges the application to just submit to the tax and penalty that they say you owe. If you decide to pursue an aggressive tax strategy, it’s wise to work with a firm that has a history of setting up and successfully defending these strategies. If you’re pursuing an aggressive strategy that is untried, it makes sense to consider saving probably up to 20% of the tax savings or more for your defense.

If you have $100 million tax savings, you better be willing to save $10-20 million to defend the strategy. We’ve also come to recognize as a red flag when someone tells you that there’s a section of law that predates the United States Constitution. And that a strategy that nobody knows about, you should probably run away.

Wealthy people have an incentive to hire great people to thoroughly examine the code to find opportunities. There are no secret corners of the tax code that people aren’t aware of. If it looks too good to be true, where you put your money into a structure that’s a really creative trust structure that has trust layered on top of trust and predates the United States Constitution that allows for no income tax to be paid.

These people are selling a strategy that’s going to get you in trouble. And at the end of the day, the IRS doesn’t care who told you to do it. You’re ultimately responsible. We can look at examples like Wesley Snipes who ended up in prison for tax fraud because he took bad advice. Anybody that tells you that income taxes are unconstitutional has no idea what they’re talking about.

There are a number of creative strategies that utilize the tax code that, when effectively done, create tremendous tax savings that also allow you to build wealth. The last piece of the equation when we’re looking at these strategies are the setup costs and ongoing administration fees to keep them compliant.

It doesn’t make a lot of sense to forego the tax and turn around and pay an equivalent amount of fees as you would tax. Financially, you haven’t accomplished anything and you’ve attached strings to the dollars you’ve invested versus free to use however you’d like if you would have just paid the tax.

Depending on the strategies, there’s oftentimes a fixed fee with implementation. So, the more money you put into the strategy, the lower the percentage of fees you’re paying compared to your investment. To wrap up level 3 tax strategy, we always like to fund our tax strategy starting with level 1 strategies that could be putting our kids on payroll and renting our house from the business through the Augusta rule.

And then moving on to level 2 strategies where the IRS gives us guidance and it takes investment like 401k and cash balance plan. If we still have free cash flow and we filled up those strategies, then we move on to what we call, and just discussed today, level 3 strategies. I want to emphasize that level 3 strategies are not problematic on their own.
The abuse of level 3 strategies is problematic. Even things like I mentioned earlier, conservation easements are still fantastic strategies to utilize. It just can’t be abused. The same thing with Captive Insurance. So anytime we’re putting a level three strategy together, we want to make sure we have legitimate business purpose that complies with the tax code, and we honor all the strings that are attached to that strategy.

So, if you aren’t utilizing things like the Augusta rule and take advantage of the home office deduction, you should not be concerned about complex strategy that nobody’s heard of that will completely erase your tax bill. Thank you for listening to the vital strategies podcast for links to the resources mentioned in today’s show.

See the show notes of this episode at vitalstrategies.com/episode10. Follow the Vital Strategies Podcast wherever you listen to podcasts. And if you have a few minutes, we would appreciate it. If you would rate and review the show. We look forward to having you back next week where we talk with Chad Spitzer and how you can execute on a Captive Insurance Company so you can build more wealth and live a great life.

I need to remind you that the information provided during this podcast is intended for informational and educational purposes only. It is not a substitute for professional advice. The views expressed are my own and do not represent the opinions of any entity that we do business with. Every individual situation is unique, therefore you should consult with a professional in an appropriate field before making any decisions based on the content of this podcast.

This includes seeking professional legal tax and investment advice from someone that is obligated to act as fiduciary to protect your interest.

Consulting Clients Have An Average Tax Savings Of $280,000

Access Now
  • Apple Podcast
  • Spotify Podcast

Take Your Tax Game to the Next Level! Listen Now on Your Favorite Platform!