Tax savings strategies and their pitfalls

From: alexhormozi

The key to building wealth is not how much money you make, but how much you keep [00:00:00]. This article compiles insights from over $3millionpaidintaxesand$500,000 spent on tax preparation and expert advice over five years [00:00:06]. The speaker, who recently sold a 66% stake in two companies for a $46.2millionvaluation,shareshisexperiencesandbeliefsregardingtaxminimization<aclass="yt-timestamp"data-t="00:00:53">[00:00:53]</a>.Hepreviouslyspentapproximately$1.6 million on legal and accounting fees to structure his current tax approach [00:01:19].

Core Beliefs About Tax Shelters

Based on extensive experience, four core beliefs about tax shelters have significantly improved the speaker’s life and financial standing [00:01:37]:

1. Tax shelters cost more than they save [00:01:42].
2. Tax shelters decrease net worth [00:01:48].
3. Tax shelters diminish life quality [00:01:54].
4. Tax shelters don’t make you a better person [00:02:01].

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Tax Shelters Cost More Than They Save

What tax shelters save in money, they often cost more in other resources [00:02:11]. There are three primary unacknowledged costs associated with tax shelters [00:02:21]:

1. Cost of Discovery and Conversion [00:02:30]:

   • Swampland Problem: Drawing from Charlie Munger, about 95% of tax solutions are “swampland” (not legitimate), with only 5% being viable [00:02:42].
   • Time and Attention: Significant time and attention are required to sift through illegitimate options to find the rare legitimate ones [00:03:06].
   • Conversion Effort: Even if a legitimate solution is found, there’s a substantial cost in time to vet, create new entities, transfer assets, reincorporate, and establish new contracts and banking relationships [00:03:33].

2. Cost of Upkeep [00:04:05]:

   • This involves trading valuable attention for a percentage of less valuable money [00:04:07].
   • Example: Constant Travel: A friend traveled 104 days a year between Puerto Rico and the United States to avoid U.S. taxes [00:04:14]. This attention and time could have been used to increase income by 30% or more, outweighing the tax savings [00:04:32]. Another friend missed their baby’s birth due to travel requirements for tax purposes [00:05:02].
   • Example: Captive Insurance: With structures like captive insurance, constant attention is needed monthly or quarterly to allocate funds and ensure legitimacy for insurance claims and IRS standards [00:05:32]. This attention does not provide value to the core business [00:05:47].

3. Cost of Unwinding and Fines [00:06:01]:

   • Most “big tips and tricks” are unwound by the IRS within years because the IRS is 3 to 5 years behind in closing loopholes [00:06:11].
   • Penalties: People are often fined because they used clauses for tax evasion rather than their intended purpose [00:06:26]. This can lead to owing back taxes, plus fines and interest [00:06:37].
   • Unwinding Costs: In addition to fines, there are significant legal and accounting costs to unwind the non-compliant structure [00:06:45]. This entire process diverts attention and resources that could be better spent on business growth [00:07:01].
   • IRS Intention: The tax code acts as an incentive system, with penalties and incentives designed to steer the economy [00:07:18]. For example, real estate has many tax incentives because the government wants people to invest in infrastructure and develop land [00:07:27]. Using these clauses solely for tax savings, rather than their intended economic purpose, can lead to issues [00:07:51].

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Tax Shelters Do Not Increase Your Net Worth

Paradoxically, focusing on tax shelters can decrease net worth due to the focus on increments rather than orders of magnitude [00:08:48].

1. The People Factor: The world’s wealthiest individuals often reside in high-tax areas like California and New York [00:08:39]. This suggests that simply moving to a tax-friendly area doesn’t inherently increase net worth [00:09:01].
2. Thinking Process: Increments vs. Orders of Magnitude:
   • Surrounding oneself with people obsessed with tax sheltering can lead to “majoring in the minors”—thinking about how to save 30% chunks rather than how to make 30 times more money [00:09:21].
   • Big wins, not minor savings, are what primarily drive net worth [00:09:47]. Obsessing over small savings (2% or 1%) that might be unwound later is inefficient compared to focusing on massive growth opportunities [00:09:50].
   • People disproportionately allocate attention to savings rather than to the strategies that lead to disproportionate net worth increases [00:10:10].
3. How Fortunes Are Actually Made:
   • Fortunes are made by taking a lot of risk with a little bit of money; they are maintained by taking small amounts of risk with a lot of money [00:10:50].
   • Wealth primarily comes from the appreciation of equities, not income [00:11:04]. For example, 94% of Fortune 100 growth comes from appreciation, not income [00:11:11]. What you build builds your net worth, not what you make [00:11:19].
   • Business Growth Example:
     • If a business makes $10millioninprofit(EBITDA)andisvaluedat5x,itsvalueis$50 million [00:11:34]. After 37% taxes, a $10milliondividendwouldresultin$6.3 million after-tax [00:12:00].
     • If the business grows by a conservative 20% to $12millionEBITDA,atthesame5xvaluation,itsvalueincreasesto$60 million [00:12:20]. The after-tax dividends would be $7.6 million [00:12:33].
     • The net worth increase is the business’s appreciation ($10million)plustheafter-taxdividends($7.6 million), totaling $17.6 million [00:12:41].
     • This means that 56% of the net worth increase was tax-free appreciation from the equity [00:13:24]. Increasing the value of the business provides a massive multiplier on equity that dwarfs income-based gains [00:13:38]. If a business’s EBITDA increased by 2 million and was valued at 40x (like some S&P companies), it would increase net worth by 80 million [00:14:18].
   • Therefore, letting the value of the business compound is far more impactful for wealth building than obsessing over tax savings on income [00:14:02].

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Tax Shelters Diminish Your Life

Tax shelters often lead to inverted priorities, where saving money hurts other aspects of life [00:15:01].

• Inverted Logic: The goal is to increase net worth to live where one wants and with loved ones [00:15:12]. Yet, people often sacrifice living where they want or spending time with loved ones now to increase net worth, creating a contradictory cycle [00:15:19]. The means (money) should not become more important than the goal (freedom, quality of life) [00:16:02].
• Time vs. Money: Why sacrifice an irreplaceable resource (time) for one that can be generated at will and has decreasing marginal utility (money)? [00:16:11]
• Authenticity: Claiming money doesn’t matter while sacrificing life for minor savings is inauthentic [00:16:45]. True freedom comes from not flipping priorities [00:17:13].
• The “Temporary” Argument: The idea of temporarily living in a tax-friendly area to “stack enough cash” often fails because the definition of “enough” constantly changes [00:17:30]. It’s mentally hard to transition from paying 0% tax to a third or half of income [00:17:40]. Entrepreneurs tend to move goalposts, leading to continuous dissatisfaction [00:17:56].
• Personal Example: Intentionally Defective Grantor Trust: The speaker considered an “intentionally defective grantor trust” that could have saved about $6 million in taxes [00:19:04]. However, it required waiting three years to access the money and following strict stipulations to avoid IRS scrutiny [00:19:21]. The needless worry, potential for audit, and the marginal gain of 4% savings were not worth the headache and stress [00:19:40]. This attention could be better allocated to increasing business value, which compounds tax-free [00:20:28].

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Tax Shelters Don’t Make You a Better Person

Ultimately, the pursuit of tax shelters can involve reputational risk and misaligned priorities [00:20:44].

1. Reputational Risk: The speaker prefers to be known for hard work and success rather than for escaping taxes [00:21:29]. A small percentage gain (e.g., 30% on $10milliontoreach$13 million) is not worth sacrificing one’s name [00:22:08].
2. The 85-Year-Old Self Test: This is the most useful decision-making frame [00:22:53]. From the perspective of an 85-year-old self, sacrificing youth or enjoyment for marginal financial gains seems silly [00:23:14]. Wealth will not matter as much at the end of life as time spent with loved ones in desired locations [00:23:21].
   • Casino Analogy: Life is like a casino where everyone is given a token to play [00:32:47]. You can amass chips, but at the end, the “Grim Reaper” taps you, and all chips stay on the table for others to play with [00:33:28]. Regardless of how many chips are accumulated, everyone is “taxed at 100%” upon death [00:32:40]. The focus should be on playing in a “nice casino” with good “lighting” and “people,” rather than obsessing over keeping a higher percentage of chips that will ultimately be left behind [00:34:18].

Rules of Thumb for Tax Savings

If one chooses to pursue tax savings, here are six rules of thumb [00:24:56]:

1. Understand Real Tax Savings Scenarios: Genuine tax savings typically arise when you:
   • Give up ownership or control (e.g., charitable giving, trusts) [00:25:02].
   • Utilize depreciation (e.g., in real estate, where the government incentivizes investment in infrastructure) [00:25:33].
   • Engage in deferral rather than elimination of taxes [00:26:19].
2. Factor in All Costs: Before engaging in any tax structure, find the “hair” (hidden complexities or downsides) [00:26:48]. Account for the cost of discovery, conversion, upkeep, and associated fees [00:26:51]. Be wary of sales pitches claiming “the wealthy have been doing this forever” [00:27:01]. Consider if the time, money, and attention could yield higher returns if invested in the business [00:27:12].
3. Ask Simple Questions: Don’t pretend to understand what you don’t [00:27:21]. If an expert cannot explain a complex structure simply (e.g., “to a golden retriever who speaks Spanish”), it’s either because they’re trying to confuse you or they don’t fully understand it themselves [00:27:44].
4. Seek Long-Term Practitioners: Always ask for references of people who have been using the strategy for over a decade [00:28:20]. This ensures they have gone through at least one full IRS cycle (3-5 years) without issues, indicating legitimacy [00:28:25].
5. Conduct Background Checks: Always perform background checks on the individuals and entities involved [00:29:07]. Be wary of brand-new entities or individuals with past indictments for tax evasion, even if acquitted, due to reputational risk [00:29:28].
6. Avoid Spending Just to Expense: Do not spend money you wouldn’t otherwise spend solely for the purpose of expensing it [00:30:23]. This is counterproductive, as it means spending 100% of the money to avoid paying, for example, 30-40% tax on it [00:30:40]. Only expense items that build value within the company and serve as genuine assets [00:30:57].

Personal Beliefs for Building Wealth

The speaker shares his current personal finance habits and strategies that have served him well [00:31:30]:

• Attention as the Most Valuable Asset: Never do anything that takes attention without a disproportionate return [00:31:36].
• Focus on Making, Not Saving: Pay zero attention to tax-saving schemes; instead, focus on generating income [00:31:41].
• Orders of Magnitude: Replace incremental thinking with orders of magnitude [00:31:50]. Instead of saving 10%, aim to 10x, and taxes will become a minor concern [00:31:56].
• No Regrets on Untaken Roads: Do not dwell on past financial decisions or “pennies on roads untaken” [00:32:01]. This destroys morale and shifts focus from the future to the past [00:32:05].
• Universal Taxation: Remember that everyone is ultimately “taxed at 100%” upon death, meaning you don’t get to keep any of your accumulated wealth [00:32:32].
• Money Buys Options: Money exists to buy options and freedom [00:34:30]. Do not trade optionality (e.g., where you live, who you spend time with) for money itself [00:34:33].