Climbing the Tax-Efficiency Pyramid to Lower Taxes


Tim Voorhees, Principal Partner, Matsen Voorhees Mintz Law, and President Family Office Services 


Scott Sims, Principal Partner, The Pinnacle Group


  • More than 2,000,000 Americans now earn more than $500,000 per year.  It is common to see business owners earning an extra $200,000 or more of income each year that is not needed for current lifestyle needs. This excess income is usually taxed at marginal tax rates of 50% or more unless additional planning is done. 
  • Business owners can minimize unnecessary income taxes by climbing up a “tax-efficiency” pyramid to realize greater benefits at each higher level.
  • The most powerful income tax strategies typically generate income tax deductions in the year investments are funded, then can grow tax-free and make tax-free distributions.
  • The most effective planning instruments typically involve the integration of legal, investment and insurance strategies. Collaboration among professional advisers is therefore more important than ever.

To illustrate the impact of taxes, it is useful to look at how taxes reduce returns across time.   Consider an owner who has $500,000 of excess income (e.g., income not used for lifestyle expenses) this year or over the next few years. If the 50 percent rate on contributions applies along with the 38 percent rate on withdrawals, the $500,000 is worth only $662,287 in 30 years.  On the other hand, if the owner invests the $500,000 in vehicles that generate current tax deductions and avoid taxes on investment income and distributions, the $500,000 can grow across 30 years to be worth more than $5,000,000.  Which would you prefer your half-million of extra taxable income grow to -- $662,000 or $5,000,000?

The impact of taxes will vary depending on the timeframes and investment returns. The following table shows the power of tax-efficient investing with different assumptions: 

Obviously, investments will perform better if there are no taxes on the contributions, accumulation, and withdrawals. Fortunately, American tax policy encourages the pre-tax funding of investments using a variety of planning instruments discussed below.  

Sorting through the different tax planning options may seem like a herculean task; however, the pyramid diagram simplifies the decision process. The six levels of the pyramid graphic, explained below, illustrate how business owners can be rewarded for advancing from traditional to more innovative strategies.

Level 1: The bottom level on the pyramid depicts how most owners receive their income. Their paychecks show heavy FICA, FUTA, SUTA, and other payroll taxes as well as withholdings for state and federal taxes. As indicated on many paystubs, more than half of the income can be lost to taxes at level 1. Moreover, after-tax investments in retirement vehicles can trigger additional taxes, as indicated on the above table. Obviously, clients need to find more tax-wise solutions!

Level 2: Climbing the pyramid to level 2 affords clients opportunities to invest in ERISA qualified plans. Such plans include 401(k) plans as well 403(b)s, SIMPLE plans, profit-sharing plans and defined benefit plans. While employee deferrals used to fund qualified plans will still be subject to payroll taxes, the heavy state and federal income taxes are deferred until money comes out of the qualified plans.

Level 3: Business owners and highly compensated employees often want more tax benefits than qualified plans afford. Too often, the top-heavy rules limit the amount of contributions by highly compensated owners and executives. To work around the ERISA restrictions, financial planners offer a variety of non-qualified deferred compensation plans.

Level 4: The Level 4 solutions include a variety of charitable planning instruments that allow for large income tax deductions when they are funded as well as tax-deferred growth on the plan balances. Moreover, the distributions may have only moderate withdrawal taxes. For example, charitable remainder trusts (CRTs) can distribute tax-free or capital gains income. These charitable tools can be custom-designed for each individual to start retirement income when income is most needed or tax rates are lowest. For these reasons, the charitable tools at level 4 can provide better bottom line benefits than those generated at levels 1-3.

Level 5: Business owners focused on retirement security and income may reject level 4 solutions because “charity begins at home.” Fortunately, there are charitable solutions, such as a Super CLAT designed with the current low 7520 rate that can increase what goes to the donor throughout retirement. For substantial benefits from non-charitable tools, employers will often take deductions for a Section 162 plan.

Level 6: Creative planners continue to find synergistic combinations of planning instruments that can provide benefits that exceed those illustrated in Level 5. Capital Split Dollar (“CSD”) helps employers take income tax deductions for funding tax-free retirement and death benefits for key executives. An Employee Stock Ownership Plan (“ESOP”) can provide tax-free build-up of assets. When the ESOP is combined with a charitable trust, the resulting “ChESOP” can produce both tax deductions in the early years and tax-free income in later years.


As businesses mature, generating excess income for their owners, the need for creative income planning becomes all the more important. Successful business owners needn’t settle for solutions limited to level 1 or level 2 of the tax-efficiency pyramid. There are compelling reasons and great financial rewards for reaching higher - to levels 3, 4, 5 and 6 in the tax efficient lifetime income planning process.