Your Tax in '06: Personal tax planning

Tax planning should be within the letter and the spirit of the law and adequately disclosed in tax returns.

taxes88 (photo credit: Courtesy)
(photo credit: Courtesy)
Tax planning should be within the letter and the spirit of the law and adequately disclosed in tax returns. Consideration also may be given to requesting an advance Israeli tax ruling where appropriate, such as where the Israeli tax law is unclear or where large amounts are involved. Tax planning falls into two main categories: * Last minute planning - more politely referred to as short-term planning. Can still be effective. * Longer-term planning - for the thoughtful investor who plans his finances by reference to his stage and status in life. Tax planning is one ingredient in this. First, short term planning. This may typically take the form of reducing the overall tax rate and/or deferring the tax liability on re-invested income. Both Israeli and foreign taxes should be taken into account. It may be worthwhile investing as an individual if you consider the following: * Five to 10 year exemptions in Israel for new or returning residents. * People thinking of moving to Israel may consider establishing an overseas investment vehicle before their arrival to help optimize such tax benefits. But use of certain companies in an offshore or onshore country that does not have a tax treaty with Israel may soon be reportable, under tax shelter proposed rules. It is vital to obtain specific tax advice. * Low Israeli tax rates from 2006 (20%-25%) for income and gains from Israeli or foreign securities, whether publicly traded or not. What about long-term planning? When it comes to financial matters, every smart investor should plan ahead. This is the case whether you have means, or you just mean to have means. In essence, there are seven typical scenarios that require planning, as discussed below. These are: 1. Yuppie 2. Middle-aged 3. Just sold a business or inherited a fortune 4. Retirement 5. Giving to the family 6. Giving to charity 7. Family office In all cases, appropriate professional advice should be obtained in each country from legal, tax and investment advisors. First, let's consider Yuppies. A yuppie is someone young at heart and on the way up. He (or she) lives hand-to-mouth and should make every effort to save at least some part of his monthly income. For Israeli approved employment-related plans - retirement provident funds (kupot gemel) - employers' contributions are generally exempt and employee contributions may qualify for a 25% or 35% tax credit within prescribed limits. Let's now consider the middle-aged. A careful, middle-aged investor may not only save pennies but also invest more than a few dollars. This may be the time to consider wrapping securities investments in an appropriate life insurance policy or an appropriate mutual "fund of funds" with sub-funds for different types of investments, among other things. Tax and insurance advisors should be consulted in each country concerned. In Israel, commencing 2006, the tax rate on life policies and mutual funds may arguably be deferred and limited to 20% of income when eventually distributed to investors/beneficiaries. Regular or periodic life policy payouts may be taxed at regular rates of up to 49% (plus national insurance where applicable). However, for certain insurance annuity policies, it seems people of pension age (67 generally), or survivors, may enjoy an exemption on 35% of such payouts. US citizens residing in Israel may wish to consider a life policy that is compliant with Section 7702 of the US Internal Revenue Code, held via an Irrevocable Life Insurance Trust (ILIT). Such a policy may confer exemptions from US income tax, capital gains tax and estate tax, if applicable conditions are met, but subject to gift tax if amounts deposited exceed various annual exemptions and the $1 million lifetime gift tax exemption ($2 million per couple). For Israeli purposes, a contribution of cash should not attract Israeli capital gains tax but other assets may be taxable. The trust may be reportable to the Israeli tax authority if the settlor (grantor) or beneficiary is an Israeli resident or any amount is distributed from trust funds in a tax year to a beneficiary. In addition, an investor and his spouse each should have valid wills that specify how their estates should be handled upon their eventual demise. Otherwise, if either spouse dies "intestate" (without a will), his/her estate will have to be allocated as specified by law. This may be different from what they wanted and also may take far more time than the court probate process for dealing with assets covered by a will. In order to validly draft or amend a will that works well in each country concerned, consult lawyers and tax advisors in each country where assets are located. Next, suppose you have just sold a business or inherited a fortune? At this point, an insightful person no doubt will see the wisdom of re-assessing living requirements, investments and estate succession plans. In addition, a smart investor may want to ensure that children and grandchildren can live well enough but cannot recklessly waste all the assets. This is a classic non-tax reason for establishing a family trust. From the tax perspective, the beneficiary, trustee and settlor of a "foreign resident settlor trust" or an irrevocable "foreign resident beneficiary trust" with foreign assets may arguably not be taxable in Israel in certain cases involving irrevocable discretionary trusts with assets located and managed entirely abroad. Distributions should not be regular or periodic. Specialist advice is essential. Nevertheless, trusts must be disclosed by the trustee, and by taxpayers who settle or contribute assets to a trust, or receive any amount from a trust in the tax year. This is the case even if no Israeli tax liability arises. Residents or citizens of other countries should check the tax rules in those countries as well - the US, UK and Canada each have comprehensive trust anti-avoidance tax rules. In civil law countries - such as France, Belgium and Germany - trusts are scarcely recognized and are often liable to be challenged by the tax authorities of those countries. Consequently, caution is advisable. In the US, any trust structure must be carefully considered before and after implementation. Many different types of trust are possible under US tax law, including: * Simple trusts and complex trusts - taxable in the US unless the beneficiary is taxable (see above) even if an Israeli tax exemption might apply. * Grantor trusts - a US grantor (settlor) remains taxable (see above) even if an Israeli tax exemption might apply. * Grantor retained annuity trust - An investor (as grantor or settlor) transfers appreciated assets to a revocable trust in favor of his or her children in return for a promise to pay the grantor a prescribed annuity for a prescribed number of years. Any excess passes to the children with little or no US estate or gift tax. Arguably, there also may be no Israeli capital gains tax on the transfer if the trust is disregarded for Israeli tax purposes, but trust income and gains may be taxable to the grantor. Consideration may be given to obtaining an advance Israeli tax ruling. In cases where US taxes are lower than Israeli taxes, these techniques may, in qualifying cases, enable US citizens and green card holders to lock onto the lower US tax rates on income. In a future article, we will discuss gifts and inheritance planning and other significant matters for Israeli investors. The writer is an International Tax Partner at Ernst & Young Israel (With thanks to Ed Rieu of the Ernst & Young U.S. Desk, London)