10 steps to reduce inheritance (estate) tax for business owners

There are many options you can take to reduce your inheritance tax. Here are basic steps to reduce the tax. Inheritance tax offers many tax deductions or discount under certain situations. But as a basic, the fundamental aspects should be addressed first.

Basics

1) Estimate your inheritance and see how the tax will be reduced if certain conditions are met. You need to know first what are there and how much they are for each items. Without knowing that, you will never know what options are available to reduce your tax. For example, if you take over parent’s (or parent in law) house and will live there with your resident address moved, you will get 80% discount on the valuation of its land.

2) Those tax benefits are only available if its split of the estate is agreed by the deadline of the tax filing (10 months). It is recommended to prepare an agreement in advance among heirs. For example, it is necessary to have an agreement of the split and actually live there by the deadline of the filing to take the above mentioned 80% discount on the land valuation.

Possible options to reduce tax

The below are real world feasible steps to reduce the tax. Some of them require to set up a co:

1) Buy life insurance by parents money. The money received from insurance is still to be counted as taxable base, you will get deduction of the taxable asset by 5 million yen times number of heirs. If the insurance money is 30 million yen, which should be close to the amount that was paid from the decedent money, you have already reduced taxable base by 20 million yen (presuming that the number of heirs is 4 for example).

2) Make gift to heirs every year. 1.1 million yen per year is tax free of gift tax by each person. This will reduce your taxable assets steadily. If you have 4 heirs and have 10 years before die, you will save 44 million yen in tax base (1.1M * 4 persons * 10 years).

3) Create a company and pay salaries to heirs. Real work has to be done to justify the salaries and keep its records of work. If you are a business owner, majority of your estate should likely come from the valuation of your own company. This is to reduce the valuation of the shares.

4) Create companies under names of heirs and pay fees to them. Again, real work has to be provided.

5) Borrow money to buy properties. Valuation of properties are usually much lower than its real market price. If you borrow money of 100 million yen to buy a condominium in Tokyo, the market price of the condominium may be still around 100 million yen but the valuation for the inheritance tax will likely be 70 million yen. You already manage to have reduced the tax base by 30 million yen.

6) Pay rents in advance or pay for other expenses to harm the balance sheet of the company. Then make gift to heirs in form of shares.

7) Make gift in form of properties to spouse for residence. It is tax free up to 20 million yen. It is a special tax benefit designed to stimulate the economy.

8) Same concept as the above. Your parent can make gift for your children’s education by 15 million yen. You need to open a special bank account for this education purpose and all the withdrawal from the account will have to be reported.

There is a rumor that the tax authority is considering revision on overseas property depreciation

I have not confirmed the source yet but there is a talking in tax community that the tax authority is considering to limit deductible depreciation expenses on overseas properties.

As you may know that second handed houses can be expensed over relatively shorter period. The depreciation expense are allowed to use the 20% of the original life year if it is older than the original life year.

For example, the life year defined for a wooden house by the tax law is 22 years. If you buy a wooden house which is older than 22 years, you are allowed to expense the cost of the house (except the land price portion) over 4 years through depreciation calculation (22 years * 20%).

If you buy a house of 60 million yen and if the house portion and the land portion can be split into 50:50, you can claim depreciation expense of 7.5 million yen (60 million * 0.5 / 4 years) per year over the next 4 years.

Because your rent income usually is much lower than this amount (let’s presume it will be 2.4 million yen a year), and you also have other expenses (let’s say 1 million yen), your loss will be 6.1 million yen (2.4M – 1M – 7.5M) that can be offset against other income (e.g. salary).

As you can see, it has huge impact to reduce your tax. On top of this, when you sell it, the tax rate on capital gain is only 20%. So, if you are in the higher tax bracket, say 50%), you save the income tax of 50% by the amount of loss, and when you sell it, you only have to pay 20%. It surely sounds like a very good deal, no?

The tax authority knows this and is said to be considering to stop this type of practice because this does not sound fair.

If it comes soon, the new restriction will come in by January 1, 2018. If you are thinking of buying a property because of the tax benefit, you may want to consider more on financial elements such as your future return on investment.

Japanese qualified stock options

With stock options being qualified, the gains will be taxed as capital gain (flat 20.42%) and it will be taxed only at the sales of the shares (as opposed to being tax at the exercise on the gain as salary income which is taxed with progressive tax rate).

Qualified stock option has to meet the following conditions:

1) Person to be vested are employee, director or executive director, not owning more than 1/3 of its shares,
2) Stock option has to be exercised after two years and within 10 years from the vesting date,
3) Strike price in total has to be within 12,000,000 yen per person,
4) Strike price has to be higher than the fair value at the time of vesting, and has to be granted for free,
5) Stock options cannot be transferable,
6) Once the stock are issued, it has to be managed by a qualified financial institutions, and
7) It has to be reported to the tax office by Jan. 31st of the next year (Shiharai chosho).

Please note that auditors or external consultants are not eligible for qualified stock option.

Well known tax saving setting by buying properties abroad

Well known structure

Buying properties abroad has become a well known structure for saving setting among individuals in high income tax brackets. Properties abroad are especially popular because of two major reasons.

1) The split of the cost between building and land is much more favorable overseas. In Japan, especially in urban area, land portion of the acquisition cost is relatively high. In Tokyo, it normally consists more than 50% of the total purchase price, while those in NY, LA, London, and Paris, the cost of building is apparently much higher in the entire cost of the purchase. Proportion can reach to astounding 85%:15% or even 90%:10%. This means you can expense much larger portion of the total cost you actually cash out.

2) Buildings do last much longer than in Japan but you can expense them all in much shorter period because of the life year by the Japanese tax law. Because the typical life year of a new building under the Japanese tax law is 47 years. And if ones you are purchasing are second handed, its life year is 47 years minus 80% of years that were already passed. For example, if it is 80 years old (which is not unusual in Europe for example), 47 yrs – 80 yrs * 80% = negative number, and if it becomes negative, minimum life year is 20% of the original life year (47 yrs) which is 9.4 yrs.

For instance, you buy an apartment made of concrete and steal of 80 years old in Paris for 100 million yen, its life year for the Japanese tax is 9 years (as mentioned above). Its cost of land is 85 million yen (85% of the total cost), and therefore, the depreciation expense that you can deduct against your rent income is about 9.4 million yen. And if the rent income is 1 million yen per year, the loss of 8.4 million yen (1- 9.4) can be deducted from your other income in Japan (say salary).

Converting salary income today to Capital Gain in future

There is another beauty. Sometime in future, you will sell the property. The cost for the capital gain is the book value after subtracting all the depreciation expenses you have booked since your purchase. The capital gain will look very large. But you will probably benefit from the structure.

The tax rate on salary or business income can be as high as about 50% including resident tax and social insurance. By offsetting the depreciation expense against salary income in this year, you will have the same amount of capital gain, presuming that market price of the property remains the same. (It can increase in value as opposed to this presumption, of course). The tax rate on capital gain is only 20% (if you hold more than 5 plus years). In another word, you are reducing your salary income by the amount of the depreciation expense and increasing the capital gain in future by the same amount. It is almost like converting your highly taxed salary income today to lightly taxed capital gain in future.