The Sophisticated Investor

The sophisticated investor knows as much as the qualified investor but has also studied the advantages available through the legal system. Rich dad defined the sophisticated investor as an investor who knows what the qualified investor knows and who is familiar with the following specialties of law :

While not a lawyer, the sophisticated investor may base as much of his or her investment strategy on the law as well as the investment product and potential returns . The sophisticated investor often gains higher returns with very low risk by using the different disciplines of law .

By knowing the basics of the law , the sophisticated investor is able to use the advantages of E-T-C, which stand for entity, timing, and characteristic: Rich dad would describe the E-T-C as follows: “The E stands for control over the entity, which means the choice of business structure.” If you are an employee, this is not usually in your control. A person from the S quadrant usually can choose from the following entities: a sole proprietorship, partnership (which is the worst structure because you are entitled to your share of income but are responsible for all the risk), an S Corporation, an LLC (limited liability corporation), an LLP (limited liability partnership), or a

Today, if you are an attorney, doctor , architect, dentist, etc. , and choose the C-Corporation as your entity of choice in the United States, your minimum tax rate is 35% versus 15% for someone like me because my business is a non-licensed professional services business.

That additional 20% tax rate differential adds up to a lot of money, especially when measured over years. It means a non-professional would have a 20% financial head start over a professional at the start of each year within a C-Corporation.

Rich dad would say to me, “But just think about people in the E quadrant who cannot elect their choice of entity. For them, regardless of how hard they work and how much they make, the government always gets paid first through income tax withholding. And the harder you work to make more money, the more the government takes. That's because the people in the E quadrant have virtually no control over entity, expenses, and taxes. Again, people in the E quadrant cannot pay themselves first because of the Current Tax Payment Act of 1943, which started withholding of income taxes from employees. After the passage of that act, the government always got paid first.”

In America, partnerships, S Corporations, LLPs, and LLCs are often called “pass-through” entities because the income passes through the entities' returns and shows up on the owner's return. Consult a tax advisor for applicability of which entity is appropriate for your situation.

“And you always try to operate via a C Corporate entity, don't you?” I would ask rich dad.

“In most cases, ” he replied. “Remember that it is the plan before the product or in this case the corporate entity. The point is that those who operate from the B quadrant tend to have more choices and hence more control over the best entity to best make their plan work. Again, those fine points should be discussed with both your tax attorney and your tax accountant. ”

“But why a C-Corporation?” I asked. “What is the difference that is so important to you?”

“This is the one big difference,” he said, having waited a long time to explain it. “A sole proprietorship, a partnership, and an S-Corporation are all part of you. They are, in simple terms, an extension of you.”

“A C-Corporation is another you. It is not just an extension of you. A C-Corporation has the ability to be a clone of you. If you are serious about doing business, then you do not want to do business as a private citizen. That is too risky, especially in this day and age of lawsuits. When you do business, you want a clone of you actually doing the business. You do not want to do business or own anything as a private citizen, ” rich dad guided me. “If you want to be a rich private citizen, you need be as poor and penniless as possible on paper .” Rich dad also said, “The poor and the middle class, on the other hand, want to own everything in their name. ‘Pride of ownership, ' they call it. I call anything with your name on it ‘a target for predators and lawyers.'”

The main point rich dad was trying to make was “The rich do not want to own anything but want to control everything. And they control via corporations and limited partnerships. ” That is why control of the E in E-T-C is so important to the rich.

Within the last two years, I have seen a devastating example of how the choice of entity could have helped prevent the financial destruction of a family. A very successful local hardware store was owned as a family partnership. The family had been in town forever, knew everyone, had become wealthy, and was quite involved in civic and charitable organizations. You could not have asked for a more wonderful, caring, and giving couple. One night, their teenage daughter was drinking and driving, had an accident, and killed a passenger in the other car. Their lives were dramatically altered. Their 17-year-old daughter was sent to an adult prison for seven years and the family lost everything they owned, including the business. In sharing this example, I am not trying to make any moral or parenting statements; I'm simply pointing out that proper financial planning for both the family and the business might—through the use of insurance, trusts, limited partnerships, or corporations—have prevented this family from losing its livelihood.

S-Corporations or LLC corporations? Why do you want to be subject to double taxation?”

Double taxation occurs when a corporation is taxed on its income and then when it declares a dividend to its shareholders they are taxed on the dividend. The same thing can occur when an improperly structured sale of a corporation occurs and a liquidity dividend is declared. The dividend is not deductible to the corporation but is taxable to the shareholder. Therefore, that income is taxed at both the corporate and individual level.

Business owners often increase their own salaries to reduce or wipe out corporate profits and thereby eliminate the possibility of having those profits taxed twice. Alternatively, as the corporation continues to grow, the retained profits are used to expand the business and help it grow. (In the United States, a C

Corporation must justify this accumulation of earnings or it will become subject to the Accumulated Earnings Tax.) There is no double taxation unless dividends are declared.

I personally like C Corporations because I believe they provide the maximum flexibility. I always look at the big picture. When I start a business, I expect it to become a big business. Most big businesses today are C Corporations (or the equivalent in other countries). I grow businesses because I want to sell them or take them public, not receive dividends.

Sometimes, I choose a different entity for a business. For example, I just formed an LLC with partners so that I could buy a building. You should consult with your financial and tax advisors to determine the appropriate structure for your situation.

Rich dad would describe the T as timing. “Timing is important because ultimately, we all need to pay taxes. Paying taxes is an expense of living in a civilized society. The rich want to control how much they pay in taxes as well as when they have to pay them. ”

Understanding the law helps in controlling the timing of paying taxes. For instance, Section 1031 of the U.S. Tax Code allows you to “roll over” your gain in investment real estate if you buy another property at a greater price. This allows you to defer paying taxes until the second property is sold (or you may choose to roll it over repeatedly—perhaps forever! ).

Another important timing issue is provided by the C Corporation status . C Corporations can elect a different year -end for tax and accounting purposes (such as June 30, for instance) than December 31, which is required for most

individuals, partnerships, S Corporations, and LLC Corporations. This allows for a certain amount of strategic tax planning as to the timing of distributions between corporations and to individuals.

Although Robert discusses the entity and timing issues as simple tax planning vehicles, it is important to understand that all decisions related to entity selection as well as income timing issues should have legitimate business purposes and be thoroughly discussed with your legal and tax advisors. Although Robert uses these tax-planning opportunities personally, he does so with the careful guidance and planning of his legal and tax advisors .

The chart on the next page describes the various forms of business entities and related issues that you need to consider when choosing the entity right for your individual needs. It is imperative that you carefully review your individual financial and tax situation with your legal and tax advisors in choosing the right entity for your business.

As far as the third component of the E-T-C, rich dad would say, “Investors control. Everyone else gambles. The rich are rich because they have more control over their money than the poor and middle class. The moment you understand that the game of money is a game of control, you can focus on what is important in life, which is not making more money but gaining more financial control. ”

“These are the three different kinds of income. ” Rich dad would stress that I should know the difference between these three different types of income. The C of the E-T-C stands for the character of the income.

“Very much so,” he would reply. “Especially when combined with the E (entity) and T (timing) of the E-T-C. Controlling the characteristics of your income is the most important financial control of all. But you may first want to control the E and the T. ”

It took me awhile to fully appreciate and understand why controlling the characteristics of these three different types of income is so important. “It's important because the characteristic of the income is what separates the rich from the working class, ” rich dad analyzed. “The poor and middle class focus on earned income, also called wages or paycheck income. The rich focus on passive income and portfolio income. That is the fundamental difference between the rich and the working class, which explains why control of the C (characteristic) is a fundamental control, especially if you plan on being rich. ”

Each partner, including you, can enter into contracts and other business agreements

Must be same as the majority interest tax year, or principal partners. If neither, must be calendar.

General partners are totally liable - Limited partners are liable for only the amount of their investment

income or loss on their personal tax returns. Losses may be subject to limitations

Must be same as the majority interest tax year, or principal partners. If neither, must be calendar.

Partnership does not dissolve with death of a limited partner but may dissolve with death of a general partner unless the partnership agreement states otherwise

Rules vary dependent on the State - “Check the box” allows election of treatment

Rules vary depending on the State - In some States the company will dissolve upon the death of a owner or member

Shareholders appoint Board of Directors which appoints Officers who have the most authority

Shareholders risk only the amount of their investment in the corporation's stock

The Corporation stands alone as a legal entity - It can survive the death of owner, officer or shareholder

Shareholders appoint Board of Directors which appoints Officers who have the most authority

Shareholders risk only the amount of their investment in the corporation's stock

Shareholders report their share of the corporate profit or loss on their personal tax returns

The Corporation stands alone as a legal entity - It can survive the death of owner, officer or shareholder

WARNING: Please consult your financial and tax advisors to determine the entity best suited for you.

“In America and other advanced economies, even the first dollar of earned income is taxed at higher rates than passive and portfolio income. The higher rates are necessary to provide various forms of ‘social insurance,' ” rich dad would further explain. Social insurance stands for payments the government makes to various people. (In the United States, this would include Social Security,

Medicare, and unemployment insurance, just to name a few. ) Income taxes are then calculated on top of social insurance taxes. Passive and portfolio income are not subject to social insurance taxes.

“So every day that I get up and focus on working hard to earn money, I am focusing on earned income, which means I pay more in taxes,” I would say. “That is why you have been encouraging me to change my focus on what kind of income I want to earn. ”

I realized rich dad was back to Lesson #1 of Rich Dad Poor Dad. “The rich don't work hard for money. They have their money work hard for them.” It suddenly all made sense. I needed to learn how to convert earned income into passive and portfolio income so my money could start working for me.

The SEC test of a “sophisticated investor ” is a non-accredited investor who either alone or with his purchasing representative has enough knowledge and experience in financial and business matters to be able to evaluate the merits and risks of the prospective investment. The SEC presumes that accredited investors (as defined earlier as the well-to-do, who can afford to hire advisors) are capable of watching out for their own interests.

In contrast, we believe many accredited and qualified investors are not sophisticated. Many wealthy individuals have not learned the basics of investing and the law. Many of them rely on investment advisors whom they hope are sophisticated investors to do the investing for them.

Our sophisticated investor understands the impact and advantages of the law and has structured his or her investment portfolio to take maximum advantage of entity selection, timing, and characteristic of income. In doing so, the sophisticated investor has sought the advice of his or her legal and tax counsel.

Many sophisticated investors are often content investing in other entities as outside investors. They may not possess control over the management of their investments, which distinguishes them from the inside investor. They may invest in management teams without possessing a controlling interest in the company. Alternatively, they may invest as partners in real estate syndications or as shareholders in large corporations. They study and invest prudently but lack control over the management of the underlying asset and therefore have access only to public information of the company's operations. This lack of management control is the defining difference between a sophisticated investor and an inside investor.

However, the sophisticated investor still uses the advantages provided by the E-T-C analysis for his or her own financial portfolio. In Phase Four , we will discuss how the sophisticated investor applies these principles to obtain the maximum advantage provided by the law.

In addition to the three characteristics of income Robert discusses, three other general principles distinguish a sophisticated investor from an average investor. A sophisticated investor knows the difference between:

As a general rule, good debt, good expenses, and good losses all generate additional cash flow for you. For instance, debt taken to acquire a rental property, which has a positive cash flow each month, would be good debt. Likewise, paying for legal and tax advice are good expenses if they save you thousands of dollars in reduced taxes from tax planning. An example of a good loss is the loss generated by depreciation from real estate. This good loss is also called a phantom loss because it is a paper loss and does not require an actual outlay of cash. The end result is a savings in the amount of tax paid on the income offset by the loss.

Knowing the difference between good and bad debt, expenses, and losses is what distinguishes the sophisticated investor from the average investor. When average investors hear the words “debt, expense, and loss,” they usually react negatively. Generally, their experiences with debt, expenses, and losses result in additional cash flowing “out of their pockets” instead of into their pockets.

The sophisticated investor enlists the advice of accountants, tax strategists, and financial advisors to structure the most beneficial financial organization for his or her investments. He or she looks for and invests in those deals that include the E-T-C features that support his or her personal financial plan—the map he or she is following to become rich.

I remember a story my rich dad once told me about risk. While part of it has been covered in other parts of the book, it is worth repeating here. The average investor views risk from a completely different point of view than the sophisticated investor. And it is this view of risk that truly differentiates the sophisticated investor.

One day, I went to my rich dad and said, “My dad thinks that what you do is far too risky. He thinks that one financial statement is secure but you think that controlling only one financial statement is risky. It seems like such a contradiction in points of view.”

Rich dad just chuckled. “It is, ” said rich dad, continuing to chuckle. “Almost exactly opposite and contradictory. ” Rich dad paused for a moment to gather his thoughts. “If you want to become really rich,” he said, “then one of the things you will have to change is your point of view on what you think is risky and what is secure. What the poor and middle class think is secure, I think is risky. ”

I thought about that statement for a brief moment, letting the idea that what my dad thought was secure, my rich dad thought was risky sink in. “I don't fully understand. ” I finally asked. “Can you give me an example?”

“Sure,” said rich dad. “Just listen to our words . Your dad always says, ‘Get a safe, secure job. ' Is that correct?”

I nodded my head. “Yes, he thinks that is a secure way to run your life. ” “But is it really secure?” asked rich dad.

Rich dad nodded his head and then asked, “What often happens when a public company announces a large layoff of employees?”

“I don't know .” I replied. “You mean what happens when a company fires a lot of employees?”

“Yes,” said rich dad. “What often happens to the price of their stock?” “I don't know,” I replied. “Does the share price go down?”

Rich dad shook his head. Quietly he said, “No, unfortunately when a publicly listed company announces a large layoff of employees, the share price of that company often goes up.”

I thought about that statement for a moment and then said, “And that is why you have often said there is a big difference between people on the left side of the CASHFLOW Quadrant and people on the right.”

Rich dad nodded his head. “A big difference. What is secure for one side is risky to the other.”

Again rich dad nodded his head and repeated, “What seems secure to one side seems risky to the other side. If you want to be rich and keep your wealth for generations, you must be able to see both sides to risk and security. The average investor only sees one side.”

As an adult, I now see what my rich dad saw. Today, what I think is secure most people think is risky. The following are some of the differences.

Does not think of insurance as an investment. Uses words such as “diversify.”

Focuses on job security. Focuses on professional education. Avoids making mistakes.

Thinks in good or bad, black or white, right or wrong. Looks at past indicators - such as p/es and CAP rates.

Calls brokers 1st and asks for investment advice or invests alone, asking no one for advice.

Wants nothing in their name. Uses corporate entities. Often personal residence and automobile are not in their names.

Uses insurance as an investment product to hedge against exposed risk. Uses words such as “covered,” “exposure” and “hedge.”

Has both paper assets and hard assets such as real estate and precious metals. Precious metals are a hedge against government mismanagement of the money supply, also know as fiat money.

Looks for future indicators - trends, proformas, changes in management & products.

Calls broker last…after consulting with plan and team of financial and legal advisors then calls appropriate broker. Their brokers are often part of team.

Seeks external security, such Values personal self-confidence and independence as job, company, government.

In conclusion, what looks secure to some investors seems risky to others.