Articles tag:www.wealthstrategiesjournal.com,2008-06-18:/articles//8 2012-01-24T16:36:22Z Wealth Strategies Journal 2.0 (Beta): In-depth articles on estate planning and taxation, asset protection, business succession planning, fiduciary issues, high-net-worth families and family offices, insurance, investments, marketing, multi-generational values, philanthropy and retirement benefits. Movable Type Pro 4.24-en 2011 in Review tag:www.wealthstrategiesjournal.com,2012:/articles//8.6660 2012-01-20T15:34:05Z 2012-01-24T16:36:22Z Associate Editor - 3
The Year in Review
Alacritously extricating ourselves from an excruciating 2011  


"Great ideology creates great times."
--Kim Jong Il (1941-2011) 


The past year, 2011, was undoubtedly commendable in many respects that will become evident to historians someday...but for the rest of us, 2012 can't arrive quickly enough. 

Here is a look back at the wreckage of 2011, including the return of the Federal estate tax, the death of reclusive heiress Huguette Clark, the most punished philanthropist of the year, business briefs, amazing auctions, and a look at the Supreme Court's rulings in Stern v. Marshall, which ended the hopes of the estate of Anna Nicole Smith to have any share in the estate of her former husband, J. Howard Marshall. 

Before proceeding with this year's collection of interesting tales, an important reminder: January 17, 2012, is the new filing deadline under Section 1022 for those electing to apply the Federal estate tax in 2010 using Form 8939. 

Danger! Warning! 

It was a year filled with natural disasters, paradigm shifts, excessive and poor behavior, uprisings, perilous economic instability due to the European debt crises, and legislative gridlock over spending that threatened to shut down the United States government several times.  

In February, Japan experienced a massive earthquake and tsunami that resulted in a nuclear disaster at the Fukushima Daiichi plant. The cost was estimated at $180 billion and had economic repercussions around the world.

This year also saw flooding in Australia, 137 tornadoes in the southern United States in the spring, flooding of the Ohio and Mississippi rivers, and drought in eastern Africa. Hurricane Irene hit the east coast of the United States in the fall and left $7 billion of damage in her wake. 

Osama bin Laden was found and killed. There was an Arab Spring movement that was also known as the Arab Awakening. This wave of protests toppled the Mubarak government in Egypt, led to serious clashes in Syria, spread across a dozen Middle Eastern nations, and culminated in a Libyan civil war that claimed the life of Muammar Gaddafi. 

By Autumn, the spirit of uprising appeared to be contagious; protests connected loosely under the banner of "Occupy Wall Street" appeared in numerous cities and nations around the world. "We are the 99%," a saying attributed to the group, was selected as quote of the year. 

Cultural Landmarks

There were outrageous personalities in the news, such as Casey Anthony, Lindsay Lohan, Anthony Weiner, Charlie Sheen and Jerry Sandusky. Kim Kardashian, who got married and then divorced after 72 days, was selected as the most ill-mannered person of 2011 by the National League of Junior Cotillions. 

There were many notable departures. Regis Philbin and Oprah Winfrey left their television shows. All My Children signed off. Ashton Kutcher and Demi Moore broke up via Twitter. The Space Shuttle Atlantis had its final mission. Steve Jobs, Betty Ford, Andy Rooney, Jack LaLanne, and Joe Frazier passed away.  

Death Tax Walking 

We started the year with an $858 billion tax law compromise that reinstated the Federal estate tax with elective retroactivity, temporary portability, and prospective uncertainty--like a time-traveling zombie Dracula on borrowed time. So who says Congress can't be creative?

For estates of decedents dying in 2010, an important election was provided. It allows the estate to choose the carryover basis for capital gains and no Federal estate tax under the 2010 laws that took effect (pursuant to the long-awaited repeal of the estate tax) or the new Federal estate tax with a stepped-up basis for purposes of capital gains. 

The deadline for this election was postponed several times during 2011; for a while, it was November 15. When the IRS released Form 8939 in October 2011, the new deadline of January 17, 2012, was established. See IRS Notice 2011-76. 

Economic Trends

You know you've been in a recession too long when the experts debate whether the shape of the recession is a "U," a "V," a "W," or an "L." Apparently, recoveries can also take these same letter shapes. It would seem 2011 was configured as a LULU. Here's hoping for a LUV recovery in 2012. 

Greek debt threatened the stock markets and global economies and resulted in stock market swings throughout 2011. The counterpoint, gold, rose dramatically in 2011, from $1,400 per ounce to $1,950 before falling back to $1,560.

Standard & Poor's lowered the United States' credit rating from AAA to AA+, causing the Dow Jones Industrial Average to immediately drop 634 points. 

Unpunishing a Good Deed

Hedge fund manager and billionaire Leon G. Cooperman was poised to demonstrate the "no good deed goes unpunished" adage after his gift of $43 million to his private foundation resulted in $5 million in penalties and $14 million of tax for nondeductible contributions. 

The IRS relented and reduced the penalties to $29,191 for accuracy-related infractions. He had acted in good faith, based on the advice of his tax advisors, who were unaware of the restrictions on gifts to private foundations. 

Despite the reduction of penalties, the $14 million of tax on the transfer was still imposed. The moral of the story: Comply with charitable giving rules before making significant transfers, or the IRS will be the unintended beneficiary.

Amazing Auctions

SUPERMAN: A rare first issue of Action Comics was found in mint condition. It is the issue in which Superman makes his first appearance. In 1938, the comic sold for 10 cents. This year, the comic was auctioned online for $2.16 million. It was the first time a comic has sold for more than $2 million. Other copies of the same comic book broke records when they were sold for $1.5 million in 2010 and $86,000 in 1992. 

ART WORLD: Topping auctions by autumn of 2011was a painting by Francesco Guardi that sold for about $41 million, just edging out a Picasso for top honors. A number of auctions failed to meet expectations, including an Andy Warhol self-portrait that sold below the $30 to $40 million anticipated. A Claude Monet Irises painting failed to meet the $15 to $20 million minimum and was not sold. Things are apparently tough all over. A late-in-the-year auction included a Clyfford Still painting that sold for $55 million.

LOU GEHRIG: A bat and jersey used by Lou Gehrig sold for $9.5 million in June 2011.

AMAZING HOMES: Petra Ecclestone purchased the 57,000-square-foot, 150-room Spelling mansion for $85 million. However, a Russian billionaire purchased a 25,000-square-foot Silicon Valley home for $100 million in 2011.

FABULOUS: Elizabeth Taylor died on March 23, 2011; in December 2011, her belongings were auctioned for $156.75 million, $137.2 million of which was for jewelry. Numerous world records were set. It was the most valuable collection of fashion ever auctioned. The auction resulted in the most ever paid for pearl jewelry ($11.8 million for a Cartier necklace), most ever paid for an emerald jewel ($6.5 million), the most ever paid for an Indian jewel ($8.8 million for the Taj Mahal diamond), and the world record for a colorless diamond (more than $8.8 million for the 33.19-carat Burton-Taylor flawless diamond). Along with live auctions, Christies conducted its first online-only auction, received 57,000 bids, and took in $9.5 million.

Business Briefs

Delaware Trust Haven: Professor Max Schanzenbach of Northwestern University School of Law was commissioned by a coalition of Delaware law firms and financial institutions to analyze the economic impact of personal trusts created by nonresidents on Delaware's economy. He concluded that these trusts contribute $1.1 billion to Delaware's economy, produce $300 million of trustee fees, and result in $33 million in Delaware income tax revenues.

• Borders filed for bankruptcy, and Barnes & Noble acquired its assets. 

• A merger announced last February between NYSE Euronext, the parent company of the New York Stock Exchange, and Germany's Deutsche Boerse in a $100 billion deal would create the world's largest exchange for stocks and derivatives. Nasdaq OMX and IntercontinentalExchange then made a competing bid of $11.3 billion to buy NYSE Euronext, which was rejected. The merger faced review by the European Union Commission toward the end of 2011. 

• AT&T purchased T-Mobile.  

• Diamond Foods bought Pringles from Proctor & Gamble for $2.35 billion. 

• Pringles, considered a flop until the company tweaked its flavor in 1980, was Proctor & Gamble's last food brand. 

• Google acquired Motorola Mobility for $12.5 billion to compete with Apple in the cell phone and tablet markets. 

• InBev, a Belgian-Brazilian brewer, announced plans to acquire Anheuser-Busch for $52 billion, creating the world's biggest brewer. 

• British Airways and Iberia planned a $7.5 billion merger.

The Heiress

Huguette Clark, a reclusive heiress and daughter of a disgraced Senator, died in May at the age of 104. She left behind a $500 million estate and two wills, one leaving the estate to her family and one leaving nothing to relatives. 

Let's settle into a comfortable chair for this one and savor this moment. With a premise like this, one can expect a case of estranged heirs and a last-minute Will drawn in favor of a) a new caretaker, b) a much younger paramour, or c) an unsavory financial advisor, preferably named "Rufus." 

If you opted for the latter version and would agree that an accountant who is a convicted felon and registered sex offender qualifies as unsavory, then you guessed correctly. The advisors were each left $500,000 under the decedent's Will. The New York Supreme Court ignored the family's complaints about the advisors restricting access to Ms. Clark prior to her death. Investigations continue after death. 

We are left with a reminder of the first wave of American wealth from the era of Rockefeller, Carnegie, and Ford. Ms. Clark was heiress to a Montana copper mining fortune and possessed fabulous assets. 

Ms. Clark's estate included three homes, all of which have been unoccupied for decades. There was a $24 million country home on 54 acres in Connecticut. She also owned a $100 million co-op on Fifth Avenue with 42 rooms overlooking Central Park in Manhattan. And for the grand finale, she owned a $100 million, 23-acre estate on the Pacific Coast in Santa Barbara, California. 

It was the latter estate which Ms. Clark left in 1963 after her mother's death, never to return. In fact, Ms. Clark left behind all of her estates and resided in hospitals for 23 years (from 1988 through 2011), using pseudonyms while her representatives were  spending $1 million per month. 

Clark's estate includes significant art such as a Monet painting that has not been seen since 1925. The decedent also had been given a 1709 Stradivarius violin known as "La Pucelle" (the Virgin) for her 50th birthday and owned it for 50 years, but it was sold in secret for $6 million in 2006. 

Ms. Clark reportedly feared that her family was after her money and, distrustful of everyone, conducted her conversations in French. Her March 2005 Will would have left much of her estate to 21 relatives, but her April 2005 Will, written when she was 98 years old, dramatically altered the testamentary disposition so that $34 million was left to her nurse, with about $400 million left to charities and the Arts. The nurse had been randomly assigned to her in 1991. 

Anna Nicole Smith, Rest in Peace

Anna Nicole Smith was a former Playboy Bunny working in a strip club when she met Texas oil tycoon J. Howard Marshall. They married when she was 26 and he was 89. Marshall died 13 months after getting married. This kind of notorious scenario is not unheard of. In fact, it is a bit of a cliché. Yet the aftermath of this case took on a life of its own. 

Anna Nicole Smith sued the estate and at various times was awarded a) nothing, b) $448 million, c) nothing, d) $88 million, and e) nothing. To oversimplify these results, Smith was whipsawed between Texas probate courts that upheld J. Howard Marshall's will and California bankruptcy courts that sided with her. 

In hindsight, Smith and Marshall's son could have spared themselves much grief with a settlement of the $1.6 billion estate. Alas, a long battle ensued; along the way, her adversary died, her son died, and Smith died. She also starred in a reality show, had a baby with her photographer, and married her attorney. 

Smith, in turn, left a confusing Will that, despite being 18 pages long, appeared to disinherit her unborn children. Fortunately, this unintended clause was ineffective, and the horrendous draftsmanship was self-neutralizing. 

By the time we devoted an entire issue of The Estate Analyst to the case of Marshall v. Marshall in March 2007, it was unimaginable that the case, then in its 11th year, would continue for another four years. 

In 2007, we were already comparing the case to Jarndyce and Jarndyce, the fictional case Dickens wrote of in Bleak House in 1891. Little did we know that the matter would culminate in a nearly unprecedented second visit to the United States Supreme Court, now docketed as Stern v. Marshall, 564 U.S. (2011)  and that Chief Justice Roberts would open his opinion by quoting from Bleak House. Here is the passage from the first chapter from which Justice Roberts sampled: 

"Jarndyce and Jarndyce drones on. This scarecrow of a suit has, in course of time, become so complicated that no man alive knows what it means. The parties to it understand it least, but it has been observed that no two Chancery lawyers can talk about it for five minutes without coming to a total disagreement as to all the premises. Innumerable children have been born into the cause; innumerable old people have died out of it. Scores of persons have deliriously found themselves made parties in Jarndyce and Jarndyce without knowing how or why; whole families have inherited legendary hatreds with the suit. The little plaintiff or defendant who was promised a new rocking-horse when Jarndyce and Jarndyce should be settled has grown up, possessed himself of a real horse, and trotted away into the other world."

For Dickens, the Jarndyce case was criticism of the Chancery Court itself and had practitioners warn, "Suffer any wrong that can be done you rather than come here!" Ironically, by the 65th chapter of the book, the case is terminated because the entire inheritance has been exhausted on court costs. 

Here, the estate of J. Howard Marshall was not depleted of funds, but the principal parties have died, and the original legal issues have faded into obscurity. The same Supreme Court that appeared to save Anna Nicole Smith's hopes for inheritance a few years ago (Marshall v. Marshall, 2006) has now ended those hopes by ruling against the bankruptcy court's jurisdiction over certain issues. (Stern v. Marshall, 564 U.S. ___ (2011). 

The decision is certainly news to bankruptcy courts in general and, like most 5-4 Supreme Court decisions, is too close and too technical to provide a fair and just solution. 

However, to merely blame the court system for the failings of financial planners and participants along the way would be wrong. J. Howard Marshall's advisors needed to provide for Anna Nicole Smith to avoid the inevitable Will contest. And a settlement that avoided legal costs and permitted funds to be productively invested would have benefited both sides. 

Unfortunately, sometimes life imitates the worst aspects of art, and the truth is far stranger than fiction. Like the litigants in Bleak House, there were no winners in the protracted battle over J. Howard Marshall's estate.    

Postscripts: Anna Nicole Smith died in 2007 from an overdose of prescription drugs. She is survived by Dannielynn Birkhead, who is now 5 years old and lives with her father. "(S)he's loved," Birkhead said about his daughter. "She has everything she needs. That's more important than any amount of money she could have received on behalf of her mother."  Howard K. Stern was tried for obtaining prescription drugs for Anna Nicole Smith. His conviction was overturned in 2011. Stern's libel suit against journalist Rita Cosby for claims she made against both Stern and Larry Birkhead was settled out of court. 









]]> New Risks for the New Generation: Encouraging Families and Family Owned Businesses to Implement a Family Risk Management Policy tag:www.wealthstrategiesjournal.com,2012:/articles//8.6641 2012-01-17T21:38:01Z 2012-01-17T21:42:29Z Associate Editor - 3

New Risks for the New Generation: Encouraging Families and Family Owned  Businesses to Implement a Family Risk Management Policy

                                                By Patricia M. Annino

Families and family owned businesses have faced risks since this country began. Traditional risks have included the unexpected death or disability of key stakeholders; incomplete or out of date estate planning documents; incomplete or out of date corporate documents;  the lack of liquidity; the lack of a disaster plan; the lack of effective communication among key stakeholders; major changes in the competitive environment; the divorce or remarriage of a key stakeholder; out of date business valuations; the absence of an effective family governance policy; and the lack of an awareness of the boundaries between family and business. 

In addition to these traditional risks, families and family owned businesses now face new risks, including the lack of privacy in the Google world; cyber attacks; the social media risk to family reputation; global dispersion of family members and its impact on effective communication; new attacks on  business valuation; pre-nuptial agreements and post-nuptial agreements; complex alimony calculations for the family business owner (taking phantom income into account); the baby boomer transfer of wealth; the speed of innovation; the impact of the increased working lifespan of the senior generation on succeeding generations; and the very turbulent economic times.

All these risks should be brought to the attention of the family, and a risk management policy statement should be put in place to soften the blow and manage the impact. A family policy statement is an agreed upon guideline that family members have developed amongst themselves in collaboration with the family's most trusted advisors. Following the guidelines of the risk management policy statement will increase the chances that the family can protect  and sustain its wealth and preserve family harmony for generations to come. 

Key areas "at risk" for family business are Family Cohesiveness, Business Ownership, and Wealth Management. 

New Risks to Family Cohesiveness:

In the area of family cohesiveness, reputation or the family brand is at risk. Traditionally this risk was triggered by a scandal that leaked out to the press. The new way this risk is triggered is through social media. One click of the button, one facebook page or one youtube vignette can go viral instantly and affect the family's reputation and brand. It can be used in divorce actions, custody matters and employment decisions. Once viral, it is hard to eradicate. The younger generation, if not educated, is not mature enough to understand the afterlife omnipresent power of the digital era. A strong family risk management policy should include education about the dangers of social media and a morally binding decision among family members to understand the consequence of social media on the reputation of the entire family.

Another risk to family cohesiveness is the impact to individual goals and life plans. Traditional risks included the illness, death or incapacity of a key family figure. In the family business, the new risk is the increased work lifespan of the older generation, which results in the delayed succession of the middle generation. In essence, with the older generation in good physical and mental health and working far longer, the middle generation may in effect be knocked out of position and never get its day in the sun. By the time the older generation decides to move along, the individual goals and life plans of the middle generation may have been passed by; and the baton may be passed to the next generation. This new risk can be mitigated by intentional strategic planning and clear communication among all generations as to what the expectations are for the working lifespan and when the baton should/will pass.

New Risks to Business Ownership:

Traditional risks to business ownership and the economic sustainability of the family enterprise include the death or the divorce of a shareholder when proper planning is not put in place. The new risk to business ownership is the increasing attack by the courts on the family business when allocating assets in a divorce. In some states in this country, known as equitable division states, gifted and inherited assets are divisible in a divorce. This does not just include what the about-to-be divorcing family member owns when married; it also includes the expectancy of what that divorcing family member will receive in the future. Those expectancies are taken into account when determining the allocation of assets between the couple about to be divorced.  

A significant side effect to this is how a hostile soon-to-be ex spouse and attorney will value the family business assets and put that valuation into the public realm of divorce court. The goal of that hostile divorcing member is to value that business high. That valuation may do serious damage to the estate plan of the older generation. 

In addition to the allocation of assets, there is an increased risk for the allocation of alimony. Many family businesses have phantom income or Subchapter S income--income that is earned during the course of the marriage which shows up on the tax return and is plowed back into the family business. At issue is how that phantom income should be treated for alimony purposes. If it was earned during the marriage, is it marital income taken into account for alimony and child support purposes even though not actually received?  When thinking about these risks, it is important to remember that it is not the law or the court in the jurisdiction of the parent or grandparent that will control these decisions; it is the law and the court in the jurisdiction of the divorcing spouse that will control these decisions. These risks can be mitigated by a well negotiated pre-nuptial agreement or post-nuptial agreement.

New Risks to Wealth Management:

Traditional risks related to the family's wealth (including financial, intellectual and social assets) include the illness or death of the key family stakeholder, economic downturn and changes in the regulatory or legal environment. New risks are triggered by the dissipation of wealth due to generational mathematics--with each ensuing generation, the wealth is splintered--and the lack of creation of new wealth; this very turbulent economic time; the increased complexity of legal and tax matters; and the increased complexity of wealth management choices. These risks can be mitigated when the family coordinates its advisors and monitors the integration of all professional services. 

The risks are further mitigated when the family embraces and encourages financial education and financial literacy across the generations. Mentoring, shadowing, exposure to the concepts and resources along the generation continuums reduces the chances for unintended consequences.

Creation of a Risk Management Policy Statement:

A solid risk management policy contains the purpose, principle and procedure for implementation. The purpose of a family risk management policy may be to reduce the risk for family members, both individually and as a whole. Adherence to the policy would go far to protect the family's human and financial assets and minimize potential liability. The principle of the policy may be to make clear that the responsibility is to identify the areas of high risk and to do whatever possible to mitigate that risk. The procedure of the policy may make it clear that each family member is expected to:

• Achieve financial literacy with regard to his or her own wealth as well as the wealth of the family enterprise.

• Draft and have both parties sign a pre-nuptial agreement.

• Contact their insurance providers annually to review their insurance coverage to ensure that they are current and adequate.

• Have in place basic estate planning documents: will, revocable trust, health care proxy, power of attorney for financial assets.

• Participate in the development of an investment policy that is aligned with the family's shared values.

• Protect the family's reputation by learning how each individual's behavior, both positive and negative, can impact the family's reputation.

A family risk management policy statement is dynamic. It should be reviewed and adjusted as the risks that families face evolve and change.











]]> When Higher Marginal Tax Rates Helped the Economy: Professor Paleveda's Paradox tag:www.wealthstrategiesjournal.com,2012:/articles//8.6595 2012-01-08T20:20:16Z 2012-01-08T21:28:47Z Associate Editor - 3
When Higher Marginal Tax Rates Helped the Economy: Professor Paleveda's Paradox

Adjunct Professor, Graduate Tax Program, Northeastern University

The Paleveda Paradox of higher marginal rates actually helping the economy is a counterintuitive thought.

Generally, it is the thinking of the hoi palloi that lower marginal tax rates lead to prosperity, however the historical data indicates otherwise. This study takes us to 1951 where the highest marginal tax rates were 92 % until the present where the highest marginal tax rates are 35%. The study compares the returns of the S+P 500 and its relationship to the highest marginal tax rates during that time period. An abecedarian concept of taxation is to focus on the highest marginal tax rates.  This study compares the highest marginal tax rates with the growth in the economy as measured by the S+P 500.

In reviewing the data, the optimal tax rates to keep the economy moving forward falls between 39.6%-50%. The call for lower marginal rates or the benighted "tea party" movement appears only to hurt the people who are supporting the movement. The pledge not to raise taxes appears also as a pledge not to help the economy.

The years 1951-1963. Tax Rates 91-92% Growth 11.8%+-

During this time period, the marginal tax rates were a staggering 91-92%. If high tax rates could only hurt the economy, this period cannot be explained as the S+P 500 grew on an average of 11.92% (mean growth) 11.8% (median growth). The double digit growth cannot be explained along with the higher marginal tax rates and especially what happened next.

The years 1964-1970 Tax Rates 70-77% Growth 3.6%+-

The First Paradox- marginal tax rates fall and the economy slows down. During this time period, tax rates actually fell from 91-92% to 70-77%. At the same time, the economy grew at 3.6% (mean growth) or 7.7% (median growth). In any event, with lower marginal tax rates, the economy actually did not do as well as when tax rates were 91%-92%.

The years 1971-1981 Tax rates 70% growth 4.35%

The Second Paradox-tax rates continue to decrease and the economy still is sluggish. During this time period, marginal tax rates were 70% and the economy continued at an anemic pace of 4.35% (mean growth) 10.8 % ( median growth). The tax rates remained high, but the economy did not grow rapidly for a decade.

The years 1982-1986 Tax rates 50% growth 14.8%

Finally tax rates decrease and the economy grows. During this time, the Economic Recovery Tax Act of 1981 a/k/a ERTA was passed during the Regan administration and the economy encountered real growth. The mean growth 14.88% and the median growth was 14.8%. Marginal tax rates were lowered to 50% and the economy created double digit growth.

The years 1987-1992 Tax rates 28-31% growth 10.9% 

The Third Paradox- tax rates decrease and the economy slows down. During this time, the Tax Reform Act of 1986 was passed by President Regan, and the mean growth was 10.9% and the median 8.45% Even though the marginal tax rates were lowered, the economy actually sputtered compared to the time where marginal tax rates were 50%. Hence a Paleveda paradox, where lower marginal rates actually did not help the economy.

The years 1993-2000 Tax Rates 39.6% Growth 15.8%

The Fourth Paradox-Tax rates now rise and the economy has its best years.  Another Paleveda Paradox-tax rates increased and the economy boomed. During the Clinton era, tax rates actually increased but the economy responded on a favorable basis increasing growth to 15.8% (mean) and 19.9% (median). In spite of the increase in the marginal tax rate, the economy actually had its best seven years as measured by the S+P 500.

The years 2001-2010 Tax rates 35% growth 1.69% 

The Fifth Paradox-Tax rates are lowered and the economy slows. Once again, taxes were lowered to 35% and the economy sputtered to 1.69% (mean) and 6.25% median growth. George Bush passed EGTRRA in 2001 which still remains today as the bulk of the tax law in the United States.  Another Paleveda paradox, when marginal tax rates were lowered, the economy faltered once again.

What is the optimal marginal tax rate?

Is a marginal tax rate of 35% an optimal number? To achieve growth of 14.8% and 15.8%, the tax rates of 39.6%-50% were optimal rates that existed during this time period. When rates fall to 28-31%, or 35%, the economic growth also fells to 10.9% or even worse 1.69%. Hence, the Paleveda paradox. However when rates climb to 70%, the growth slows to 3.6-4.35%. This leads the reader to an optimal marginal tax rate which appears to be in the 40-50% range. The tax cognoscenti of course can argue that marginal rates make up only a part of overall tax policy and enforcement.

When marginal tax rates fall below 40-50%, the economy slows. When marginal tax rates go above 40-50% the economy also falters. We will discount for a moment the years 1951-1963 where rates were as high as 92% and the economy grew at 11.9%. When the rates fell to 70%, the economy slowed to 3.6-4.35%. In any event 11.9% growth is still not as good as 14.8% and 15.8% where the rates were 39.6-50%. 

Why do higher marginal tax rates help the economy?

This is a really good question. One answer is that money is taken out of circulation when tax 
rates are lowered as wealthy individuals are able to save more money, money that is not being spent on goods and services. Another answer is that when tax rates fall and the government borrows money to fund the deficit, this creates an economic climate that exists today. Today an ever increasing national debt looms over the entire economic base of the United States which impedes growth. Bottom line is it is difficult to conclude why higher marginal rates actually help the economy, but historically it appears the optimal rate is between 39.6-50%. In fact wealthy people may be better off with a higher marginal tax rate as the GNP appears to increase which actually will increase their wealth as much of their wealth is tied to the S+P 500. If marginal tax rates go up 5% but the stock portfolio increases 15%, perhaps that is a tax increase that makes sense.




]]> Cross Purchase tag:www.wealthstrategiesjournal.com,2012:/articles//8.6593 2012-01-08T20:06:28Z 2012-01-08T20:10:34Z Associate Editor - 3
Cross Purchase

By: Martin M. Shenkman, CPA, MBA, JD

Redemption v. Cross-Purchase: There are two categories of buyouts: (1) Redemption (entity buys equity); or (2) Cross-purchase (each equity owner, say shareholder) buys the equity (say stock) of the other.  Cross-purchase can provide several advantages, namely an increase in basis. If you buy a deceased shareholder's stock, your basis (investment) for determining capital gain if you ever sell the company is increased to reflect what you paid. Also, the shareholders, not the corporation, own the life insurance that might be used in the buyout so that the cash value isn't exposed to corporate claimants. 

Structural Options: Issues are legion, options are many: the shareholders can own the buyout insurance on each other, a partnership (LLC) could be used to own the insurance, a trusteed arrangement could be used, and other options have been advocated. No option is perfect, none are without risks, but all are more involved than most business owners imagine. Embrace the complexity or the downside could be tax and legal bumps.

Life Insurance: Will the cross-purchase be insurance funded? Partly? Entirely? Assuming all owners are reasonably insurable most opt for some insurance to minimize the financial hardship on the business of a buyout. But the value of the business will hopefully grow over time. Unfortunately, time brings age and often health issues so that additional insurance to cover that increasing value might become costly or unobtainable. Consider structuring the policy as an increasing benefit policy that grows over time.

More than Death: Life insurance won't solve the buyout issues of disability (disability buyout insurance might but it can be costly), termination, retirement, disagreement, etc. Too many shareholders focus on death to the exclusion of other issues. All need to be addressed. 

Trusteed Arrangement: If the shareholders own policies on each other's life, with 2 shareholders you need 2 policies. With 3 shareholders 6 policies. The formula is n x (n-1) for the number of shareholders. Not only is this complex but ponder, what happens with 3 shareholders on the death of the first? The deceased shareholder's estate owns policies on the two surviving shareholders that the survivor's need when the next shareholder dies. How do you get those policies to the surviving shareholders? What if a shareholder tries to borrow on or cash in a policy? All these issues can be addressed to some degree by having the policies held in an escrow-like "trusteed arrangement." What if a shareholder is sued or divorced years after the plan is put in place and the cash value of the insurance has increased? It might provide some measure of protection for the trusteed arrangement, not the individual shareholder, to hold the policies.

Who Should be Trustee: A bank or independent person should serve as trustee (escrow agent). It is preferable not to have the insureds serve. Independence can avoid problems if differences arise between the parties. It also lessens the risk of the IRS, ex-spouse or claimant, arguing that a shareholder has control over the policies. If the IRS could show that a shareholder/trustee could exercise control, it could pull the policy into the shareholder's taxable estate. Some practitioners draft around these issues, avoiding streets with potholes is safer than steering around them.

Coordination: Be sure to coordinate the trusteed or escrow agreement and the provisions of the shareholders' (or other) governing instrument.

Hybrid Buyout: The buyout might be a multi-tiered approach: corporation buys shares up to some amount, the trusteed arrangement buys the next tier of shares, the surviving shareholders then buy the final tier if the value exceeds what the corporation and trustee buy.

Transfer for Value: This sinister tax rule could taint insurance proceeds as being taxable. Consider a valid partnership of the shareholders to potentially mitigate these risks.

101(j):  These tax reporting provisions, if not complied with, can similar taint insurance proceeds as taxable income. Be sure to address them if they apply. 






]]> Intra-Family Loan Valuation Issues tag:www.wealthstrategiesjournal.com,2012:/articles//8.6577 2012-01-04T07:14:50Z 2012-01-04T07:33:52Z Associate Editor - 3
Intra-Family Loan Valuation Issues



With the looming threat of Congress passing legislation that would curtail the application of valuation discounts for minority interests in family-controlled entities, estate planners are exploring other techniques to accomplish their objectives. One method that is getting more attention is the use of intra-family loans.

From a valuation perspective, estate planners are also taking a close look at estate plans and family transactions executed prior to the credit crisis and economic malaise of 2008 and 2009. The market downturn has disrupted many estate plans as recently transferred assets have declined in value or have not met investment expectations. In some succession planning situations, the inability to obtain independent bank financing may have left no alternative but to utilize a related-party promissory note. Now, shifting risk tolerances of clients may warrant a change to the structure of a related-party debt agreement, such as an individual no longer being comfortable with a personal guarantee.

While the use of intra-family loans can provide a low risk method of achieving estate planning objectives in a volatile economy, even the best intentioned plan can lead to unexpected surprises in the form of taxable income or gift tax.

Intra-family loans, forgone interest, debt forgiveness, or a rescinded personal guarantee can trigger a gift tax, as it may be considered income to the recipient. From an IRS perspective, personal loan guarantees may be considered a transfer of economic value as a loan with a personal guarantee should allow the borrower to receive a more favorable interest rate.

The consequences of debt forgiveness, or other events, such as rescinding or buying out a personal guarantee, may warrant a valuation of that specific attribute to determine its Fair Market Value. The following section provides an overview of the valuation of a promissory note and the attributes that impact value.

Note Valuation

The method utilized to value a promissory note is dependent on the financial condition of the debtor. If there is a reasonable expectation that the debtor will be able to meet the financial obligations of the note, then the value of the note may be determined based on the present value of the future note payments discounted at a market-derived rate of return. If the debtor is unable, or if there is uncertainty if the debtor will be able, to meet the financial obligations of the note, then the value of the note is equal to the expected proceeds to be received through a liquidation or bankruptcy of the debtor.

In valuing a note, the rate of return (or market yield) applicable to the note is estimated based on the risk inherent in the investment. In other words, an investor would accept a rate of return no lower than that available from other investments with equivalent risk, and would value the investment accordingly.

Generally, the longer the term of the note, the higher the rate of return an investor will require due to the risk of changes in prevailing interest rates during the term of the note. In addition, assessing the debtor's underlying creditworthiness has an impact on the market yield. This can be assessed by analyzing cash flow and coverage ratios. Higher coverage and cash flow ratios reduce the risk that the debtor will be unable to make its regular debt service payments, thus indicating a lower yield is applicable.

If the collateral of the installment note is a private operating company, it may be possible to identify a comparative group, or class, of publicly traded debt instruments issued by companies with similar characteristics of the private company in determining an appropriate market yield. In general, the greater the collateral or security position, the lower the rate of return required by an investor. The IRS has provided guidance of the relevant factors to consider in determining the Fair Market Value of a note through Technical Advice Memorandum ("TAM") 8229001, which include the following:

- Presence of or lack of protective covenants in the note;
- Nature of the default provisions and default risk;
- Market for purchases and resale of the note;
- Financial strength of the issuer;
- Value of the security (i.e., the collateral);
- Interest rate and term of the note;
- Comparable market yields;
- Payment history; and
- Size of the note.

Components of a Market Rate of Return

In general, a required rate of return is comprised of three components: 1) a time value of money component; 2) a risk premium component; and 3) a marketability or liquidity component. The first component, time value of money, represents the rate of return that one could obtain in an investment with little or no risk of losing the interest or principal on the note. The U.S. government bond is often used as a benchmark for a risk-free investment and is considered a proxy for the time value of money.

The second component, risk premium, is comprised of many specific types of risks. For example, a portion of the risk premium represents compensation for interest-rate risk. Maturity is a major determinant of interest-rate risk. Interest-rate risk is a significant risk faced by an investor of debt instruments in the public marketplace. Additionally, investors face the variability in returns from their reinvestments due to changes in market rates (i.e., reinvestment risk) or potentially the loss of a portion or their entire investment if the borrower declares bankruptcy (i.e., default risk). Risk premiums can be directly observed by analyzing market yields of publicly traded corporate and high-yield debt in excess of the risk-free rate.

The third component represents the marketability of the investment and reflects how quickly one can obtain liquidity from an investment. Factors that affect marketability include: restrictions on transfer of the security, the pool of possible investors, the size of the security, and the amount of available information related to the issuer. The more obstacles to finding a potential buyer, the more illiquid the investment and, accordingly, the higher the rate of return one would require.

Market Yield Analysis

As illustrated in the following table, the market yield increases depending on the time horizon and the level of perceived risk of the investment. The first four securities are government-issued securities and, therefore, free of default risk. The difference in yield between the 20-year Treasury bond and the 1-year Treasury bill is due to the duration of the security, which increases interest rate and reinvestment risk. The next two yields are "investment grade" corporate bonds based on creditworthiness as determined by a rating agency. The yield spectrum continues with securities that fall below investment grade, and carry substantial default risk. Also typically considered are yields on mortgage debt and unsecured personal loans available through financial institutions. The increased risk associated with the lack of collateral causes a significantly higher yield to be demanded by the market.

S11_Intra-Family Loan_1.small preview.jpg
Assessing the risk of a promissory note focuses on three areas, including an assessment of the creditworthiness of the borrower from a financial standpoint; an assessment of the risk from a governance standpoint; and an assessment of the marketability attributes associated with the debt instrument. In other words, an analyst seeks the answers to the following questions:

Will the borrower have the cash to pay the debt obligation?
Can the debt holder prevent the borrower from acting in a high-risk manner?
How difficult will it be to gain liquidity?

S11_Intra-Family Loan_2.preview.jpg
The table above presents an example of a basic note valuation, whereby the expected cash flows are discounted to present value based on the market interest rate, and summed to determine the Fair Market Value of the note.

While most of the attributes of a note valuation may seem intuitive, certain attributes of intra-family loans can present complex valuation issues. Let's say the individual's financial position, or risk tolerance, has changed in light of recent economic conditions such that they wish to rescind, forgive, or be bought out of a personal guarantee on an intra-family loan. This event may warrant a determination of the Fair Market Value of the personal guarantee associated with the promissory note.

Valuation of a Personal Guarantee

S11_Intra-Family Loan_3.jpg

Empirical studies and market data are fairly limited as it relates to the specific valuation of a personal guarantee. The appropriate methodology to apply will ultimately depend on the facts and circumstances of each case. The following describes two ways in which the valuation assignment may be approached.

Income Approach - "With Scenario" versus "Without Scenario"

To the extent an income approach can be applied in valuing the subject note, one approach to ascribing value to a personal guarantee would be to determine the reduction in the market-derived interest rate made possible by the personal guarantee. That is, a comparison of the value derived from each scenario utilizing different market interest rates - one scenario assuming the personal guarantee is present and the alternative scenario incorporating an interest rate assuming that no personal 
guarantee exists.

This approach would entail a determination of the applicable market interest rate absent the personal guarantee. As such, the steps would include an assessment of:

- The probability of default over the term of the loan;
- The likelihood of utilizing the personal guarantee; and
- Quantification of the incremental yield on the applicable market interest rate.

Put Option Theory

While a personal guarantee on a debt instrument and a put option on a stock may seem completely unrelated, option pricing theory may provide some insight into developing a framework. This method employs the theories and formulas used to value stock options in the valuation of other financial claims. Unlike common stock, a personal guarantee on debt has a return spectrum that is asymmetric in nature. In other words, a guarantor has limited upside if the borrower's creditworthiness or collateral position improves, but nearly limitless downside if the borrower becomes insolvent and the collateral position declines in value. The asymmetric nature of a personal guarantee on debt is similar to the characteristics of stock options and, thus, makes it possible to consider an option-pricing model to estimate the value.

When an investor sells a put option, the seller receives a payment for writing the option in exchange for agreeing to pay the buyer of the option an amount equal to the exercise price less the asset price, upon exercise by the buyer. When the seller of the put option enters this agreement, the investor is accepting a contingent liability. The contingent liability will become an actual liability only if the asset price of the security declines below the strike price. Because the seller is paid a premium for writing the option, the fee received is inherently the value of the contingent liability.

The most widely used option pricing model is the Black-Scholes Option Pricing Model (the "Black-Scholes Model"). The Black-Scholes Model is an arbitrage-pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage (i.e., riskless profit). The model calculates the price of a traditional put option by analyzing the volatility and opportunity cost of investing in the underlying asset. The Black-Scholes Model relies on five variables:

1| Asset price; 
2| Exercise price; 
3| Term; 
4| Risk-free rate of return; and 
5| The underlying asset's price volatility (or level of risk).

Once a valuation analyst has made an assumption for each of the inputs into the Black-Scholes Model, these inputs can be used to calculate the value of the put option. However, it is important to understand the impact that each of the inputs will have on the value of the option. For example, the longer the term and the higher the volatility, the more likely it is that the option will ultimately be exercised, producing a higher value of the option. Alternatively, the higher the asset price relative to the strike price, the less likely the option will be exercised. This will result in a lower value of the option because the asset has more room to decline in value before the option will be in the money.

S11_Intra-Family Loan_4.small preview.jpg
As presented above, in the case of valuing a personal guarantee on debt, some of the terms pertaining to traditional stock option inputs of the Black-Scholes Model are converted to terms pertaining to a personal guarantee. The theory, however, remains the same.

In establishing a framework to value debt and debt attributes, an assessment of the collateral position is required. That is, an investor would consider the value of the assets that are available to cover the claim of the guaranteed debt. For the purpose of this analysis, this total asset value is identified as enterprise value ("EV"), which is comprised of both the debt and equity components of the enterprise.

In this example, as presented in the following table, the exercise price of $50 equates to the value of the debt that is being guaranteed. In order for the personal guarantee to be invoked, the EV (i.e., total asset value) of $100 would have to decline below the value of the debt, and would result in the effective exercise price of the option. Further, the asset price, (i.e., the stock price in a traditional option model) equates to the EV in the personal guarantee valuation, and represents the total value that is available to satisfy the claim of the guaranteed debt. If the EV declines to $40 at maturity, or in the event of default, the guarantor is obligated to pay $10 to cover the deficiency and make the issuer whole. Given the existence of this potential downside protection, an issuer would accept a lower rate of return on debt with a personal guarantee relative to a debt instrument in which a personal guarantee is absent. The other inputs of the Black-Scholes Model remain virtually the same as a traditional stock option valuation.

S11_Intra-Family Loan_5.small preview.jpg
An individual that guarantees a debt obligation is entering into a similar arrangement as that of a seller of a put option. If the value of the company that issued the debt declines to a level below the amount of the debt outstanding, the guarantor has the obligation to fund the shortfall. The personal guarantee is effectively a put option, with the debt value being the exercise price. For accepting this contingent liability, the guarantor needs to be compensated by the borrower, just as an investor that sells a put option on stock is compensated through the premium paid by the buyer. As such, in consideration of the other inputs in the model, including the volatility of the EV and the length of time that the personal guarantee is in effect, the calculated price of the option results in the estimated value of the personal guarantee.

Conclusion

While valuation issues involving family transactions and related party debt are common, in light of the current economic and legislative environment, issues involving intra-family loans are becoming more prevalent in estate planning. In addition, certain debt attributes can be quite unique, posing challenging valuation assignments. The valuation framework and methodology described in this article present both basic and sophisticated valuation concepts and other important attributes for estate planners to consider in structuring intra-family loans.  
















]]> Warning! The Service Believes S Corporations are Undervalued tag:www.wealthstrategiesjournal.com,2011:/articles//8.6559 2011-12-27T17:26:24Z 2011-12-28T03:53:26Z Associate Editor - 3
Warning! The Service Believes S Corporations are Undervalued


The 1999 decision of Gross v. Commissioner ("Gross") fundamentally changed the manner in which valuation experts and the Tax Court treat valuations of S corporations. FN1. In this decision, the Tax Court accepted a valuation that concluded that S corporation shares, due to the unique tax characteristics of S corporations, are inherently more valuable than C corporation shares. FN2.

Prior to the Gross decision, valuation experts for both taxpayers and the Internal Revenue Service (the "Service") typically valued S corporations using measurements of income that included a provision for corporate income taxes commonly referred to as "tax-affecting". FN3. This treatment does not fully reflect the unique tax characteristics of S corporations when compared to C corporations. FN4. Since 1999, the Tax Court has been consistent in its rejection of this valuation practice. When confronted with the valuation of an S corporation, the Tax Court has accepted valuations which remove the "hypothetical" corporate income taxes from the analysis, thereby significantly increasing the appraised value of the S corporation; sometimes by as much as 60% or more.

Emboldened by Gross and subsequent decisions, the Service continues to challenge taxpayers submitting S corporation valuation reports which fail to properly address the tax-affecting issue. Augmenting their challenges is the failure of the valuation profession to reach a universal consensus on an appropriate methodology to capture an S corporation's unique tax characteristics.

With well over four million S corporations in existence, the impact of this development has significant consequences. FN5. What is the validity of the Service's position and how can taxpayers support their S corporation valuations?

Case Law and the Significance of the S Corporation Issue

Prior to the Gross decision, the Service, in its IRS Valuation Guide for appeals officers, stated that corporate income taxes should be included in S corporation valuations. Additionally, tax-affecting was specifically approved by the Tax Court in Estate of Hall v. Commissioner and Rudolph M. Maris v. Commissioner. FN6.

At issue in Gross was a gift valuation of an approximately 1.9% interest in common stock of a soft drink bottling company. Consistent with prevailing valuation practices at time, the expert for the taxpayer tax-affected the company's earnings. The expert for the Service, however, argued that tax affecting was inappropriate since the company, as an S corporation, does not pay corporate taxes. In addition, there was no evidence presented that the company would cease to continue as an S corporation, and the company historically distributed 100% of earnings.

At trial, the Tax Court considered valuation opinion reports prepared by experts for the taxpayer and the Service. Based on the evidence presented, the Tax Court concluded that simplistic tax-affecting of the earnings of the company was not a reasonable approach to the analysis. Consequently, the Tax Court accepted the valuation proposed by the Service, which eliminated tax-affecting from the analysis, and concluded a substantially higher indication of value.

The impact of not tax affecting, given current and expected corporate tax rates, can be dramatic as illustrated in the hypothetical example below:

Gross Chart.jpg

Subsequent to Gross, the Tax Court again raised the S corporation tax-affecting issue in the 2001 Wall v. Commissioner decision. FN7. Unlike Gross, the Tax Court found fault with both experts and ultimately accepted the Service's original statutory deficiency notice while concluding that the taxpayer had not adequately supported the use of pretax P/E multiples (essentially a tax-affecting analysis) as a reasonable means to address the S corporation tax-affecting issue. Specifically, the Tax Court noted that "because this methodology attributes no value to . . . S Corporation status, we believe it is likely to result in an undervaluation of . . . stock."

Unlike Gross and Wall, in the 2002 case of Heck v. Commissioner, the Service's position against tax-affecting was accepted by both experts. FN8. Interestingly, the Service's expert applied a 10% discount for lack of control which it believed incorporated the "additional risks associated with S corporations." The Tax Court, by accepting this analysis, effectively incorporated a significant premium in value for the company's status as an S corporation while mitigating it slightly with a small discount.

The 2002 case of Estate of William G. Adams, Jr. v. Commissioner extended the application of an S corporation premium to that of a controlling interest. FN9. Adams is also notable in that, while not discretely applying a reduction to cash flows for hypothetical corporate income taxes, the taxpayer's expert increased the discount rates applicable to the company's income. As discount rates are derived from transactions in securities of tax-paying entities (C corporations), they produce after-tax rates of return. The taxpayer's expert increased the discount rates to a pre-tax rate of return. The expert reasoned that a pre-tax discount rate could be appropriately applied to the pre-tax cash flows of the company. In citing Gross, the Tax Court found the analysis to be an improper means to essentially tax-affect the earnings of the S corporation.

In the 2006 Robert Dallas v. Commissioner matter, the valuation experts for the taxpayer tax-affected the company's earnings while the expert for the Service did not. FN10. However, the taxpayer's experts attempted to distinguish this situation from Gross on the basis that the corporation in Gross distributed virtually all its income to shareholders while the company in Dallas distributed only an amount necessary to satisfy the shareholder pass-through tax liabilities. As such, the distribution of approximately 100% of income results in returns to shareholders over-and-above that of the associated tax liabilities. In contrast, distributions to shareholders that are less than the associated tax obligation results in no such return to shareholders. In rejecting this reasoning, the Tax Court indicated that the Gross treatment of tax-affecting "is independent of the proportion of earnings distributed."

Accordingly, since 1999, the Tax Court has consistently:

  • been presented with improper valuation models that do not adequately address the unique tax attributes of S corporations;
  • rejected the simplistic application of hypothetical corporate taxes to the income of S corporations, thus concluding a significant valuation premium;
  • recognized that certain tax characteristics of S corporations are detrimental which may mitigate the corporate and shareholder tax benefits;
  • concluded that a tax-affecting valuation premium for S corporations applies to both minority and controlling equity interests; and
  • disallowed efforts to effectively tax affect an S corporation's income by arbitrarily adjusting discount rates or pricing multiples
Determining a Reasonable Adjustment

Any adjustment to the valuation of an S corporation relative to a C corporation must first recognize the fact that S corporation shareholders do not avoid taxation, but rather avoid a second layer of taxation on the dividends and capital appreciation of their ownership interest. Since the Tax Court has not been presented with a valid S corporation model in any of its decisions, it has been unable to properly consider the valuation related tax differences between S corporations, C corporations, and their respective shareholders. It is our view that if the Tax Court had been presented with a valid S corporation model, the concluded indications of value would likely have been substantially lower.

We understand the reasoning of the Tax Court given the evidence presented at various trials, however, when the valuation of an S corporation excludes any form of tax-affecting, the indications of value become so large that they begin to violate economic principles related to the cost of conversion of a C corporation to an S corporation. In other words, at valuation premiums implied by not tax-affecting, investors would constantly be asking themselves "why would I pay 66% more for an S corporation than a C corporation, when I could buy a C corporation and convert it to an S corporation for much less?"

The cost of a C-to-S conversion typically includes explicit costs (e.g., legal fees, accounting fees, valuation expert fees, etc.) and implicit costs (e.g., higher cost of capital, inherent tax liabilities associated with the recognition period, limitation on shareholders, etc.). Typically these costs would not approach the costs reflected by the level of premiums suggested by relevant Tax Court decisions. In addition, if a 60% valuation premium was available to qualified C corporations by conversion to an S corporation, an arbitrage opportunity would exist to maximize shareholder value by conducting C-to-S conversions. The trend towards pass-through entities as the preferred corporate organizational form is undeniable; however, C corporations have not converted en masse to avail themselves of such an opportunity. The anecdotal evidence suggests that the valuation premiums reflected in relevant Tax Court decisions are overstated.

The S Corporation Economic Adjustment Model

One valuation model that has gained widespread usage, credibility, and acceptance is the S Corporation Economic Adjustment Model ("SEAM"), developed by Daniel R. Van Vleet, ASA, of Stout Risius Ross, Inc. FN11.

When using the SEAM, analysts first value the S corporation at its C corporation equivalent value. This is important since the discount rate used in the Discounted Cash Flow Method and the P/E multiples used in the Guideline Public Company Method are derived from publicly traded C corporations. Consequently the proper application of these methods requires that the earnings used to estimate S Corporation value are also on a C corporation equivalent basis. However, as properly noted by relevant Tax Court decisions, this type of analysis is simplistic, incomplete, and does not properly reflect the differences in tax attributes between S corporations, C corporations, and their respective shareholders. The SEAM is based on these tax differences and is used to adjust a C corporation equivalent value to an S corporation value. When properly conducted using current tax rates, the SEAM adjustment is typically in the 10% to 20% range over the C corporation equivalent value. This adjustment is significantly less than the 60%+ premiums suggested by various Tax Court decisions.

The following table provides an illustrative example of the components of the SEAM and the differences in economic benefits at the shareholder level between S corporations, C corporations, and their respective shareholders. The table was prepared using the income tax rate assumptions below:

C corporation effective income tax rate of 35%;
Individual ordinary income tax rate of 35%;
Capital gains tax rate of 15%; and
Income tax rate on dividends of 15%.

Chart 2.jpg

The table illustrates the income tax-related differences between C corporations, S corporations, and their respective shareholders and reflects the foundational basis of the SEAM. As demonstrated, the net economic benefit derived by S corporation shareholders is 17.65% greater than the net economic benefit derived by C corporation shareholders under the selected tax rate assumptions. In this example, the SEAM would increase the C corporation equivalent value of equity by 17.65%. As discussed, this adjustment is significantly lower than the 60%+ premiums suggested by relevant Tax Court matters.

In addition to the application of the SEAM, analysts should also consider the unique risk characteristics of S corporations vis-à-vis C corporations, including the following:

  • loss of S corporation status due to an involuntary revocation for violations of IRS regulations,
  • distributions by S corporations that are insufficient to pay for the shareholder pass-through income tax obligations,
  • maximum number of shareholders limited to 100,
  • prohibition against foreign ownership,
  • prohibition of ownership by a C corporation,
  • inability to become publicly traded without conversion to a C corporation,
  • inability to create different classes of stock other than voting and nonvoting,
  • changes in the ordinary income tax rate, and
  • requirement that all shareholders consent to certain corporate transaction structuring events.

These factors may have an impact on the desirability of an S corporation equity security when compared to an identical C corporation equity security. A comprehensive valuation analysis of an S corporation should consider these differences and incorporate them into the analysis.

Conclusion

So far, the Tax Court has not been presented with a valid S corporation valuation model that properly addresses the unique tax attributes of S corporations. Consequently, the Tax Court has rendered its opinions based on the decision to simplistically "tax-affect" or "not tax-affect". Unfortunately, when conducted in isolation, both tax-affecting and not tax-affecting are equally wrong. A proper S corporation valuation analysis will consider all the tax attribute differences between S corporations, C corporations, and their respective shareholders and adjust the value accordingly. The SEAM is an S corporation model that considers and properly reflects these differences.

The Service is becoming increasingly aggressive with taxpayers that fail to properly address the tax-affecting issue in their valuations of S corporations. It is important for any valuation of an S corporation to include specific adjustments that explicitly reflect the significant tax differences between S corporations and C corporations. Failure to do so may expose the owners of S corporations to a "red flag" audit issue with the Service. In addition, a valuation analysis that fails to consider these important tax differences would be correct only by coincidence.


FOOTNOTES
____________________________

1 Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001).

2 Because the tax attributes of pass-through entities are consistent in lacking the applicability of Federal corporate income taxes, the article utilizes the terms "S corporation" and "shareholder" to refer to pass-through entities and their owners in general.

3 "Tax affecting" is deducting hypothetical, corporate-level taxes in valuation models when no such legal obligation exists.

4 Unlike C Corporations, S corporations are not subject to federal income taxes at the entity level. Also, the distributions (i.e., dividends) of S corporations are generally not taxable and the capital appreciation of the stock is not taxable to the extent it is attributable to the retained earnings of the corporation. On the other hand, C corporation shareholders pay taxes on dividends upon receipt and capital gains upon sale of their stock. Also, unlike C corporations, the shareholders of S corporations report their pro-rata share of the income of the corporation on their personal tax returns and pay the taxes accordingly.

5 Statistics of Income, Internal Revenue Service, http://www.irs.gov/taxstats/

6 Hall, T.C. Memo 1975-41. Maris, T.C. Memo 1980-144.

7 John E. Wall v. Commissioner, T.C. Memo 2001-75.

8 Heck v. Commissioner, T.C. Memo. 2002-34.

9 Adams v. Commissioner, T.C. Memo. 2002-80.

10 Robert Dallas v. Commissioner, T.C. Memo 2006-212.

11 "The Van Vleet Model", Business Valuation & Taxes: Procedure, Law & Perspective, edited by Shannon P. Pratt and U.S. Tax Court Judge David Laro, 1st ed., New York: John Wiley & Sons, Inc., 2005.







]]> Cross Tested Retirement Plans: The Future of Tax and Asset Protection Planning for Small Business tag:www.wealthstrategiesjournal.com,2011:/articles//8.6503 2011-12-13T18:45:03Z 2011-12-13T19:35:09Z Associate Editor - 3
Cross Tested Retirement Plans: The Future of Tax and Asset Protection Planning for Small Business



TYPES OF RETIREMENT PLANS

The 401(k) Plan.

A 401(k) plan is a plan to defer salary also known as an elective deferral plan. 401(k) plans was passed into legislation in 1978 effective for the year 1980. Today, these plans are the most popular plans in the United States, yet the most tax inefficient. The reasons these plans are tax inefficient is that social security taxes and Medicare taxes are taken out first before the assets are placed into the plan. In a pension plan or profit sharing plan, these taxes are not paid as the contributions generally come from employer contributions not employee contributions.

The reason the plans are popular is the 401k plan contributions generally come from the employee salary deferral and not from the company. The burden of funding is placed on the employee, not on the corporation.

The additional taxes can add up to 15.3%. Today, the tax "load" is around 12.4% due to the tax break that will last until 2012 under TRUIRJCA 2010.

The 401(k) plan has advantages such as you can contribute more to the 401k plan than an IRA. For example, you can contribute $16,500, otherwise known as the 402(g) limit, to the 401k as opposed to $5,000 to an IRA. You can also add an additional $5,500 to your 401(k) if you are over age 50. Loans are also available as well as hardship withdrawals. In service withdrawals are also available to a 401k. The disadvantages of a 401k as opposed to an IRA are the administration cost can be higher as ADP and ACP test must be completed each year. Loans and withdrawals can add additional fees. There is a penalty of 10% if withdrawals are made for participants who are under age 59 ½ and they do not met any of the exceptions under section 72t. The stock market may make corrections prior to retirement, and the account may not be sufficient for retirement.

The IRS has certain guidelines in establishing a 401k plan. The rules are set forth in section 401(a) and the timing of establishing a plan is set out in Rev. Ruling 81-114. In many cases, a company will establish a "safe harbor" plan and contribute 3% of pay to the employees to satisfy nondiscrimination testing. These plans must be established by October 1, Non-safe harbor plans may be established by December 31st, but a plan established on January 1 will not receive a deduction under section 404 for employer contributions nor a deferral under 401k for employee contributions. The plan must be in writing and communicated to the employees.

Types of 401(k) Plans.

There are several different types of 401k plans. There is the traditional 401k plan, the safe harbor 401k plan, and the SIMPLE 401k plan. You can also have a ROTH provision in the plan document along with provisions that allow loans, in service withdrawals etc. The plan document may be a prototype, a volume submitter or even a custom plan.

Traditional 401(k) Plans

In a traditional 401k plan, an employee can elect to defer up to $16,500 of their salary which can represent 100% of their salary. The employee is 100% vested in the amounts deferred as they are considered a form of vested compensation. If the employer makes a contribution to the plan, such as a profit sharing contribution, the employer contribution can be subject to a vesting schedule which may be a 6 year graded vesting schedule or a 3 year cliff vesting schedule. In many cases, the employees who are NHCEs do not defer and only the HCEs defer which creates a plan failure of meeting the nondiscrimination rules and the contributions are then refunded back to the employees or a QNEC contribution must be made.

Due to these plan failures which will not be known until the end of the year, many companies elect to set up a safe harbor 401k.

Safe Harbor 401K.

A safe harbor plan must provide for employer contributions which are fully vested. These contributions usually consist of a 3% of pay contribution or a "match". The 3% of pay contribution cannot be used to pass the gateway test to cross test a plan. These safe harbor plans must make an election by October 1.

SIMPLE 401(k).

A SIMPLE 401K IS NOT SUBJECT TO NONDISCRIMINATION TESTING. This plan must have fewer than 100 employees who receive at least $5,000 in compensation to be a participant in the plan. If another plan is found along with a SIMPLE plan, the SIMPLE plan is terminated and the assets are refunded. No penalty will apply according to ASPPA technical tip 71. Administration is basically following the terms of the plan document.

In all 401k plans, the assets are held in a trust and are in the custody of an asset manager who is also a fiduciary of the plan. A trustee who selects the platform and asset manager may be held liable for selecting the asset manager. See LaRue-Supreme court of the United States granting standing to plan participants that file lawsuits against plan administrators.

A 401k plan requires information to be sent to the employees known as a Summary Plan Description or SPD. The SPD is created with the plan document and must be given to all plan participants. The SPD is not the plan and if found in conflict with the plan, the plan document controls, see CIGNA v. ARMANA Supreme Court of United States 2011. A plan in operation must follow rules concerning contributions, vesting, nondiscrimination testing, investment options, fiduciaries, government reports, distribution options and compliance. Eligibility and Participation are also important. A Participant is eligible if they are over age 21, however if the plan document allows, a younger age may be used to become a participant. For example, your document can allow participants who are age 18 to become eligible in the plan. Your document cannot exclude participants who are over age 21. Union employees or nonresidents may also be excluded from eligibility in a plan.

A plan can also require one year of service before an employee becomes eligible. A plan can also use a shorter period such as all employees are immediately eligible. A plan can have a two year eligibility, however in this case the employees are now 100% vested in company contributions. A plan can provide that at least 1000 hours of work must be done to become eligible to participate in a plan. The plan document could have a lower amount of hours, such as 700 or 500 but cannot state 2000 hours or 1100 hours to become eligible. Contributions are limited by what is known as the 402(g) limit which this year is $16,500. Excess contributions may be carried over into a future year without penalty, but cannot be deducted in the year contributed. The 404(a) (7) limit also applies if the participant receives contributions from more than one plan. This limit does not affect the elective deferrals, but does limit the amount of employer contributions the participant can receive. The participant can work for many corporations, but the limit is $16,500 per person under 402(g).

A SIMPLE 401k provides a match of up to 3% of compensation or a non-elective contribution of 2% of pay. The maximum amount that can be deferred by the employees into a SIMPLE 401k plan is $11,500 by the employees. The total contribution to a plan is 100% of compensation up to a maximum of $49,000. If the participant is over age 50, the participant can add another $5,500.

Combining plans under Section 404 (a) (7).

This section is also known as the "combined plan limitation". There has been a recent change allowing the deduction of both a profit sharing plan and a defined benefit plan contribution provided that the defined benefit plan is covered by the pension benefit Guarantee Corporation. This law was enacted in the Pension Protection Act of 2006 to encourage pension plans to become fully funded. However, some plans are not covered by the PBGC such as "professional service providers" with less than 25 employees see ERISA 4021 (13).

If the defined benefit plan is not covered by the PBGC, the tax deductible contribution to a profit sharing plan will be limited to 6% of pay. This can create problems in a cross tested DB/DC plan where 7.5% of pay is needed to pass the gateway test and perhaps additional contributions are needed to pass 401(a)-4 independently. The maximum deduction of 6% of pay also uses a maximum considered compensation of $245,000 under 401(a) (17).

PBGC coverage is not elective. A plan is covered by the PBGC according to the rules of the PBGC or they are not covered. The definition of "professional service providers" leaves open a question of medical technicians. You may obtain a letter ruling from the PBGC if you are not clear about the status of PBGC coverage.

Other Rules:

Vesting

The employer contributions are vested over time only if the employee remains employed by the corporation. Vesting can be graded over 6 years or 100% after 3 years. These schedules are deemed equivalent. Employee funds are always 100% vested to the employee. Employer funds may be forfeited back to the plan if the employee quits or is terminated. If the plan is terminated, the employee becomes 100% vested in the plan.

Beneficiary of the plan

A 401k may have a trust as a beneficiary. A trust must meet certain requirements. The trust must be valid under state law, irrevocable at death, the beneficiaries must be reasonably identifiable and the trustee of the plan provided with a copy which has a list of all the beneficiaries and an agreement that if the trust is amended, the trustee of the plan will receive the amendments within a reasonable time. The documentation must be provided by October 31 of the year following the year of the owner.s death.
Nondiscrimination testing.

Nondiscrimination testing involves setting up two distinct identifiable classes of employees.

1. The Highly compensated employee a/k/a/ HCE which by definition is an employee who has received more than $110,000 in compensation or is a 5% or greater shareholder.

2. The Non-highly compensated employee a/k/a/ NHCE who makes less than $110,000.

Testing compares contributions or benefits between the two groups. These tests are found in 1.401(a)-4. In a defined contribution plan, the test generally is based on a percentage of contributions to a plan. For example, each employee received 10% of pay to a plan. One employee received $20,000 based on his $200,000 pay another received $2,000 based on his $20,000 pay. In a defined benefit plan, tests are based on a percentage of pay at normal retirement age as a form of benefit. For example, one employee receives $20,000 a year for life and another $2,000 a year for life. However, the employee who is to receive $20,000 a year for life will retire in 5 years and the funding is significant where the employee who is to receive $2,000 a year for life is to retire in 45 years and the funding is very small. Cross testing is taking the funding rules of defined benefit plans and applying them to a defined contribution plan to pass nondiscrimination testing.

401(k) Plan Investing.

Investment options are important. Today, many insurance companies and mutual fund companies have platforms that are used to invest qualified plan funds and keep required records and valuation of the funds. A person who sells financial products to a plan may be a fiduciary to a plan was PTE 84-24 may not apply and the advisor becomes an "inadvertent fiduciary". Several cases have reached the courts regarding this issue including Reich v. Lancaster and New York Life v. Consolidated Beef. Generally a fiduciary is a person who has discretionary control of the plan funds or provides investment advice to the plan for a fee or has discretionary authority over the assets.

These rules are in a constant flux as to who is a fiduciary as the Department of Labor attempts to expand jurisdiction over the advisors to the plan.

Penalty for withdrawals 72(t).

If a participant removes funds out of a plan prior to age 59 ½, the participant may be subject to an additional 10% tax on top of the income tax. The penalty does have several exceptions such as uniform systematic withdrawals through life expectancy, purchase of a home etc. The penalty is 25% if the funds come from a SIMPLE IRA. After age 59 ½ but prior to age 70 ½ funds may be withdrawn without the penalty, only ordinary income taxes.

Early distributions that are not subject to this penalty include tax free distributions from Coverdell education savings accounts, tax free scholarships, Pell grants, employer provided assistance and veteran assistance. First time homebuyers where the maximum amount is 410,000 and the amount is used to pay acquisition cost before 120 days. The residence must be the main house of the person, the spouse, child, or grandparent. The exception to the penalty applies if the homebuyer did not own a home during a 2 year period prior to the purchase. A qualified reservist may also be exempt if called into active duty after September 11, 2001 and on active duty more than 179 days. The distributions may be from a 401k or 403 b plans if made from the time of active call to close of the active duty period.

401(k) Plans

A plan trustee must provide a fidelity bond. On January 1, 2012, new disclosure rules concerning the commissions and fees associated with the plan will go into effect. A participant is entitled to receive summary plan descriptions, individual benefit statements and a summary of material modifications to a plan. Reporting is on a form 5500 or a 5500EZ if a one participant plan. The reporting is made through EFAST. If a plan has not filed or filed late, this may be done through the VFCP program usually with a $750.00 penalty.

Lawsuits.

Today there are over 1,150,000 attorneys in the United States. The small business owner or professional could be a target of an unjust suit which can cost them everything as they near retirement age. Cross-tested plans have been made exempt from these lawsuits by the Bankruptcy Restructuring Act of 2005. Thus, the Cross-tested plan is not only a good method for saving taxes, but also a method for protecting the asset from creditor claims.

CROSS TESTING

Cross testing is a method used to meet nondiscrimination rules. The formula for EBAR is important to known in creating a cross tested 401(k) profit sharing plan otherwise known as a new comparability plan. When performing a test for nondiscrimination, the elective deferrals are not considered as they represent "employee contributions". The test is measured on the "Employer contributions". A defined contribution plan such as a 401k profits sharing plan uses employee benefit allocation rates as opposed to employee normal accrual rates and most valuable accrual rates which are used in a defined benefit plan. Hence the name EBAR!

Example: John age 60 has his employer contributes $10,000 into an annuity that will give him 5% for 5 years. Sue age 25 has her employer contributes $2,000 one time into an annuity at 5% for 40 years. The plan has a normal retirement age of 65.

After 5 years, John will have a balance of $12,763 and Sue will have a balance of $14,080. Sue came out ahead as she had a longer time to invest the funds even though her contribution is lower. Sue is a HNCE and John is a HCE. The formula to test a plan is basically:

Amount invested * (1+i) ^
i= interest rate
^= amount of years.
Two ways to test a DC plan.
1. On an allocation basis: Regs. 1.401(a)-(4)-2
2. On a "benefits basis" Regs. 1.401(a)-(4)-8(b).

Testing on an allocation basis is simple, testing on a benefits basis there are two rules that must be complied with.
1. The "Gateway rule" under Reg. 1.401(a) (4)-(8) (b) (1). In effect January 1, 2002 this can start at 5% of pay to a maximum of 7.5% of pay.
2. The "equivalent accrual rule" found in reg. 1.401(a) (4)-(8) (b) (2).

There also is a special rule for target benefits found in Reg. 1.401(a) (4)-(8) (b) (3).

FUTURE VALUE OR LUMP SUM.

The first step is to cal calculate the future value or what the lump sum will be in a plan where a series of deposits will be made into a plan. These series of deposits with an assumed interest rate will determine a "lump sum" amount. Treasury regulation 1.401(a) (4)-(B) (2) (II) (b) refers to this as "Normalization". Normalization is a lumps sum amount at retirement.

The second step is to convert the Lump Sum into a lifetime income. The math is easy, divide the lump sum amount by the annuity purchase rate. In English, how much of a lifetime income will this sump sum give me?

Annuity Purchase Rates

What is an annuity purchase rate? If I give you one million dollars, what will you give me as income for life at age 65 where if I die you will keep the lump sum. Two factors come into play, the interest rate assumption and the mortality assumption. The lifetime income can be.

A. $100,000

B. $80,000

C. $60,000

The APR is found in regulation 1.401(a) (4)-12. If you use a standard mortality table, the annuity rate is usually expressed as an amount that would be received monthly. For example, if you give me $1,000 I will give you $6.00 per month. This amount will need to be multiplied by 12 to annualize the rate for testing purposes. 6x12=72 or a 7.2% return.

The third step is to take the benefit and divide it by the individual 414s compensation to arrive at an EBAR. Some actuaries have called this the equivalent benefit accrual rate, but the regulations never use the term EBAR. Each employee in a plan will have an EBAR and each employee in a plan is either a HCE or a NHCE.

EXAMPLE

John age 60 makes $230,000 a year. The plan contributes $46,000 a year to John or 20% of pay. Sue makes $20,000 a year. The plan contributes $1,000 a year or 5% of pay. It appears impossible to pass nondiscrimination testing on the basis of allocation as John receives $46,000 to Sue $1,000. It looks bad a percentage of pay $20% as opposed to 5%.
How do you pass nondiscrimination testing?

Look at "equivalent benefits".

First calculate John.s EBAR. The APR is 115.39 based on the 1983 IAF table of 8.5% (46,000* 1.085^5) *12/115.39/230,000=3.128.
John has an EBAR of 3.128.

Second, calculate Sue.s EBAR. (1,000*1.085^22)/115.39/20,000=3.129.
Sue has an EBAR of 3.129.

The HCE and NHCE are placed into a "rate group". John has a lower EBAR 3.128 then Sue 3.129 and the plan is deemed nondiscriminatory. Fill out your schedule Q demo 5-6 and wait for the IRS to give you a favorable opinion letter.

John received $46,000 and Sue received $1,000 and the plan is nondiscriminatory as to "benefits". Why is this possible? First, the age of the participants, John is 17 years older than Sue. Second, the compensation is different, $230,000 a year as opposed to $20,000. The maximum considered compensation for testing purposes today is $245,000. Finally the interest rate assumption used of 8.5%. If you used a rate of 7.5% a different result would take place.

John (46,000*1.075^5)*12/115.39/230,000=2.986
Sue (1,000* 1.075^22)*12/115.39/20,000=2.553
The plan fails testing.

John's EBAR is now greater than Sue and you fail testing. But what happens if John was born in the latter half of the year and is really close to age 61 with 4 years to retire. If you use the age nearest birthday in testing, the EBAR is lower. Is Deference given to the administrator today under Conkright v. Frommett for plan testing?

Lower EBAR. (46,000*1.085^4)*12/115.39/230,000=2.883 results when a shorter time frame is used for retirement.

The General Test.

Employer contributions are considered nondiscriminatory in a defined contribution plan by following a "uniform allocation method" or the "general test" which I found in defined benefit plans. Regs. 1.401(a) (4)-2. Hence the name "cross testing" as you are using the DB rules to pass testing in a DC plan. The employer provided benefits under a defined benefit plan are considered nondiscriminatory if each "rate group" under a plan satisfies 410(b). A "rate group" consists of each HCE and all other employees who have a "normal accrual rate greater than the HCE and also a most valuable accrual rate greater than the HCE.

The example found in Reg. 1.401(a) (4)-3(c)-4 provides a demonstration of rate group testing. A company has 1100 employees employee 1-1000 are considered nonhighly compensated employees ad employees 1-100 are considered highly compensated employees. There are 100 rate groups as there are 100 highly compensated employees.
A calculation is performed to determine the normal accrual rate and the most valuable accrual rate for each group.

Assuming Rate Groups are as follows:
NHCE 1-100 has an NAR of 1.0 and a MVAR of 1.40,
NHCE101-500 has a NAR of 1.5 and a MVAR of 3.0
NHCE 501-750 has a NAR of 2.0 and MVAR of 2.65 and
NHCE 750-1000has a NAR of 2.3 and a MVAR of 2.80.

Next the highly compensated employees
H1-50 has a NAR of 1.5 and a MVAR of 2.0.
HCE 51-100 have an NAR of 2.0 and MVAR of 2.65.
Rate group H1-H50 satisfies the ratio percentage test as 90% of the NHCWEs have a higher NAR and MVAR then H1-50. Only N1-100 has a lower rate and we needed 70% to pass.

But what about H51-100? H51-100 is lower than all NHCE groups except N501-750 and N750-100. H51 passes the ratio percentage test-why?
H51-100 represents 50% of the HCEs and N501-1000 represents 50% of the NHCEs.
50/50=100% and we need 70% to pass.

Example 2 provides the same facts except H96 has an MVAR of 3.6%. No other employee that is an NHCE has this high rate. The plan would pass by treating H96 as not benefitting as this group consistitutes less than 5% of the HCEs. The commissioner may determine the plan is nondiscriminatory based on these facts and circumstances.
Hated example 2 gives a 5% "fudge factor" along with discretion to the commissioner. Actuaries hate facts and circumstances test as this test cannot be quantified.

NAR-Normal Accrual Rate.

What is a "normal accrual rate"?

In the regulations it is the increase in the employee.s accrued benefit during the measurement period divided by the employees testing service expressed as a dollar amount or average annual compensation.-Basically an EBAR.

MVAR-Most Valuable Accrual Rate.

What is MVAR-same definition except it is the increase in the "most valuable optional" form of payment. The optional form of payment is determined by calculating the normalized QJSA associated with the accrued benefit. If the plan provides a QSUP, the MVAR must also take into account the QSUPP in conjunction with the QJSA.

In cross testing a profit sharing plan, there usually is no QSUPP or QJSA to take into account and hence no MVAR. MVAR in defined benefit plans includes early retirement subsidies, early retirement benefits, etc. The measurement period can be the current plan year, the current plan year and all prior years or the current plan year and all prior and future plan years.

Secret Formula
Step 1. Lump sum at NRA or
Contribution* (1+i) ^
Step 2.
(Lump sum/APR)*12=annual benefit.
Step 3. Benefit /compensation=EBAR

Cross- tested plan designs takes into account calculating EBARs, passing the gateway and general test.

chart1.png
chart2.png

Conclusion:

Cross Tested plans simply determine contributions on a "benefits basis" as opposed to a contribution basis. As the population of baby boomers need to fund more for retirement, a cross tested plan can be an ideal solution as they are generally older and more highly compensated and will achieve larger contributions on a benefits basis. In addition, the assets are protected from lawsuits and creditor claims.










]]> When Can I Retire? Answers from the Historical Record tag:www.wealthstrategiesjournal.com,2011:/articles//8.6486 2011-12-09T17:11:24Z 2011-12-11T03:12:13Z Associate Editor - 3
When Can I Retire? Answers from the Historical Record

by: Wade D. Pfau, Ph.D., CFA
Director of Macroeconomic Policy Program and Associate Professor
National Graduate Institute for Policy Studies (GRIPS)
7-22-1 Roppongi, Minato-ku, Tokyo 106-8677 Japan
Email: wpfau@grips.ac.jp
phone: 81-3-6439-6225
website: wpfau.blogspot.com


This study extends a framework for determining whether one is on track for a sustainable retirement. The reason this is important, is both because traditional wealth accumulation targets do not provide the most effective framework for retirement planning, and because even if they did, financial market volatility makes it very hard to judge whether one is on track to meet such targets. As an alternative, simply combine the pre-retirement and post-retirement periods to determine which actions should be taken prior to retirement in order to have accumulated enough to afford one's desired retirement expenditures. The answers derive from what would have proved safe in rolling periods of the historical data. The tables in this article show retirement ages that would allow for a sustainable retirement based on one's current wealth, proposed future savings rates and asset allocation, and desired income replacement rate in retirement. The tables may show some unrealistic retirement ages for people who would be unable to maintain their jobs with a constant real salary for so long. However, such impractical retirement ages should really just serve as a wake-up call about the unrealistic nature of one's current plans.

Acknowledgments: I wish to thank Peter Benedik, Ricky Hutchins, Michael Kitces, Jean Lesperance, and Felix Salmon and for their helpful suggestions about what could be interesting to consider in this article, or for helping me to refine my own thinking about these issues.

 
Introduction

Traditional retirement planning calls for one to decide on how much she wishes to spend from her savings during each year of retirement, decide on a "safe" withdrawal rate to use with her savings, and then figure out the wealth accumulation target for the retirement date that will provide the desired spending levels matched to the intended withdrawal rate. Tracking progress in this framework then involves determining whether one's current wealth accumulation is sufficient to reach the intended target at retirement.

In two articles I published in the Journal of Financial Planning this year ("Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle" in the May issue, and "Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work" in the October issue), I argue strongly against the traditional retirement planning approach. 

Traditional retirement date wealth accumulation targets do not provide the most effective framework for retirement planning. Instead of aiming for a wealth target, one should consider the pre-retirement and post-retirement periods together to see what must be done prior to retirement in order to accumulate enough to afford one's desired retirement expenditures. The metric for retirement planning then becomes either the savings rate to be used over a fixed number of working years, or the feasible retirement age for a given savings rate. The idea is: save the appropriate amount for enough years, invest it in a simple low-cost balanced portfolio, and you can be confident about your retirement plans (based on history's worst-case scenario) regardless of your actual wealth accumulation or necessary withdrawal rate at the retirement date.

This means, do not aim for a wealth accumulation target at retirement, but rather aim to accumulate enough wealth to actually finance your desired retirement expenditures. Though they sound similar, these two concepts are not the same. When considered together, the lowest sustainable withdrawal rates (which give us our idea of the safe withdrawal rate) tend to follow prolonged bull markets, while the highest sustainable withdrawal rates tend to follow prolonged bear markets. This will tend to provide some flexibility for those retiring in a bear market; they will experience a harder time meeting a wealth target, but should be able to withdraw at a rate above the historical worst-case sustainable withdrawal rate anyway. It is those retiring at the end of a bull market (especially, retirees in early 2000) who should be concerned that even though their wealth accumulations are quite large, they may end up needing even more than expected to fund their retirements. The focus is on savings, not on accumulations.

Besides, even if wealth targets were otherwise effective, financial market volatility makes it hard to judge whether one is on track to meet such targets. Even 10 years before retirement, all of your hard work toward saving for retirement provides you with very little indication about where you will end up in another 10 years. Market volatility in those final 10 years overwhelms what came before. This is because one's portfolio is hopefully at its largest just before retirement, which means that a given percentage return has a much larger absolute effect than the returns experienced earlier in one's career. Average long-term returns cannot be applied to short periods, as there is still too much volatility.

The purpose of this article is to explore some loose ends from the "Getting on Track" article. That article provides a framework for mid-career individuals to develop a progress report about their retirement plans by showing which savings rate they may still need to use and how much longer they may still need to work. How would the results change for a younger, mid-career individual who wishes to plan for retirement sustainability without relying on Social Security income? What impacts do annual percentage of portfolio fees have on sustainable savings rates and retirement ages? And how different are the results for a retiree making plans to enjoy a sustainable retirement through age 90, rather than through age 100? 

Methodological Framework

The "Getting on Track" article explains the full methodology. I suggest that the way to know if one is on track for a sustainable retirement is to consider hypothetical individuals with the same current situation and retirement plans, but who reached their current age at different points in history. See how these hypothetical individuals fared over rolling periods from the historical data. Determine what else must be done (what savings rate is needed over how many more years of work) so that all the hypothetical individuals from history facing the same current circumstances could have retired successfully. This provides a recommended strategy calibrated to history's worst-case scenario. In most cases, such extremes were not necessary, but there is always a possibility that one's own retirement period will create a new worst-case scenario.

I examine the case for a 40-year old planning for events over the remainder of her life, charting a course which starts from each year in the historical period. The purpose is to determine the earliest retirement age that will allow for a sustainable retirement for different savings and asset allocation strategies, for different retirement spending levels, and for different current wealth accumulation levels. The worst-case scenario from the rolling historical periods is identified as the "safe" retirement age. In Table 1, I assume an individual makes plans for potentially surviving to age 100, while Table 3 shows the case for survival plans through age 90. 

The individual earns a constant real salary for each year of employment and contributes her new savings to her portfolio at the end of each working year. She uses a simple indexing strategy for her investments, rebalancing her portfolio each year to a fixed asset allocation of large-capitalization stocks and short-term commercial paper. The data are for 1871 to 2009 from Robert Shiller's website. Withdrawal amounts are defined as a replacement rate from final pre-retirement salary and are kept constant in real terms. The withdrawal rate this represents is not important in the framework, nor is the actual wealth accumulation when retirement begins. I investigate the case for a 40-year old wishing to replace 85% of her final salary with withdrawals from her accumulated wealth. Adding Social Security on top would create a generous retirement income, though younger people may wish to plan for a retirement without income from Social Security or other defined-benefit pensions. Without a need to save any longer, an 85% replacement rate would keep post-retirement and pre-retirement spending relatively comparable, though each person will have a unique answer about how much they hope to spend in retirement. In Table 1, there are no fees, but a 1% annual account balance fee is added for Tables 2 and 3. 

When Can a 40-Year Old Retire?

What must a 40-year old still do (in terms of saving and working) in order to reasonably expect a successful retirement? The answer depends on her current retirement savings (wealth accumulation expressed as multiples of her constant real salary).  First, Table 1 shows various facets of the answer in terms of a "safe" retirement age for a 40-year old wishing to plan for expenditures through age 100. Circumstances included in the table are current wealth accumulations, the future savings rate, the asset allocation choice, and the retirement income replacement rate. This table shows the tradeoffs for retirement: wanting to either retire earlier or spend more in retirement will naturally require saving more prior to retirement. 

Pfau.table1.jpg

From the top of Table 1, for any given savings rate, the "safe" retirement age drops for a 40-year old with increasing amounts of current wealth. For a 40-year old without any savings, retirement can still be possible at some point, though even with a 30% savings rate, retirement cannot safely begin for 29 years until age 69. As well, for a given wealth level, saving a larger percentage of future income provides another way to bring the "safe" retirement age down. For a 40-year old wishing to retire by age 65, who plans to replace 85% of salary and use a 60% stock allocation, various combinations of wealth and savings stand out. With current wealth equal to two multiples of salary, retirement at 64 is possible with a 30% savings rate, and with more wealth there is generally a tradeoff that each additional multiple of current wealth allows the future savings rate to decrease by around 5%. 

The second part of Table 1 shows how retirement ages relate to asset allocation for a 40-year old targeting an 85% replacement rate and planning for a 15% savings rate. Historically, higher stock allocations would have supported lower "safe" retirement ages. While not shown here, since this table shows only the worst-case scenario, higher stock allocations would have also provided more upside potential. However, one must take caution because the United States enjoyed a remarkable historical period, and high stock allocations in the future may not always work out so well. 

The final part of Table 1 shows how the replacement rate decision relates to current wealth, for a fixed 15% savings rate and 60% stock allocation. As a general approximation, the table shows that each additional multiple of salary currently held by the 40 year old would allow the replacement rate to increase by about 15% for a given retirement age. Dan Ariely recently made a blog post saying that financial planners gave bad advice because his survey shows that people would actually like to replace 135% of their salary in retirement. However, this part of the table makes clear about the sacrifices involved. Increasing the replacement rate from 85% to 130% would require delaying retirement by between 5 and 8 years, depending on the current wealth accumulation. 

Pfau.table2.jpg

Next, Table 2 shows the "devastation of compound fees." For this table, I assume that 1% of the portfolio balance is deducted each year for the 60 year period. This could be interpreted as a fee which is deducted from a portfolio which otherwise performs as well as the benchmark indices, or it could be interpreted as underperformance against the return indices. Comparing directly the numbers in Tables 1 and 2, one can see how much the retirement ages increase as a result of the fees. For instance, consider someone with a 60% stock allocation, 85% replacement rate target, 3 multiples of salary, and a 20% savings rate. In Table 1, this 40-year old found that 65 is the "safe" retirement age. But Table 2 shows that with the portfolio underperformance, this age increases by 5 years to 70.  The other direction to observe in the tables is how much higher the savings rate must be for the same retirement age. Again with this same scenario, in Table 1 the 40-year old could have retired at age 70 with a 10% savings rate rather than the 20% savings rate in Table 2. This is the devastation of compound fees: the 1% account balance fee would require the 40-year old to save an extra 10% of salary over a 30 year period to age 70, or to otherwise work an additional 5 years, just to be able to pay the portfolio fees over the 60 year period between ages 40 and 100.

Pfau.table3.jpg
Finally, Table 3 maintains fees, but shows how much relief is provided by retirees who wish only to assume a maximum lifespan of 90 years rather than 100 years. The impacts are larger for those who would otherwise be forced to retire very late in their lives, but there may only be a 1 or 2 year retirement age different for those on track to relatively early retirements. For those making good progress toward retirement, the impacts of planning to age 100 (a seemingly conservative assumption) are relatively minor.




_____________

References

Pfau, Wade D. 2011a. "Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle." Journal of Financial Planning 24, 5 (May): 42-50. http://www.fpanet.org/journal/CurrentIssue/TableofContents/SafeSavingsRates/

Pfau, Wade D. 2011b. "Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work." Journal of Financial Planning 24, 10 (October): 38-45. http://www.fpanet.org/journal/CurrentIssue/TableofContents/GettingonTrackforaSustainableRetirement/





]]> A Gift From Congress: Gift Up to $10 Million Tax-Free tag:www.wealthstrategiesjournal.com,2011:/articles//8.6463 2011-12-02T18:28:05Z 2011-12-02T18:36:00Z A Gift from Congress: Gift Up To $10 Million Tax-FreeBy Stephen Colella, CPA and Sarah Wulf, CPAFor a limited time, married taxpayers can make lifetime gifts of assets worth up to $10 million without paying federal gift taxes or other... Associate Editor - 3
A Gift from Congress: Gift Up To $10 Million Tax-Free

By Stephen Colella, CPA and Sarah Wulf, CPA

For a limited time, married taxpayers can make lifetime gifts of assets worth up to $10 million without paying federal gift taxes or other transfer taxes.

The exemption for gift taxes, estate taxes, and generation skipping transfer (GST) taxes was fixed at $5 million per taxpayer when Congress extended the Bush-era tax cuts through 2012. Married couples can now give away up to $10 million and single people can give away up to $5 million without incurring gift or GST taxes, as adjusted for prior taxable gifts, which is a pretty powerful planning opportunity.

While the estate tax currently offers the same exemption, one needs to pass away in order to take advantage of this $5 million exemption. With the exemption for gift tax, estate tax, and the GST tax decreasing when the current Bush Tax Cuts extension expires, one may lose the opportunity to take advantage of the $5 million estate tax exemption, whereas the $5 million lifetime gifting and GST planning opportunity can be done now.

The gift and estate tax exemption amounts will revert to $1 million per taxpayer on January 1, 2013, with the GST exemption amount reverting to an inflation-adjusted $1 million per taxpayer, if Congress takes no action between now and December 31, 2012. There are many practitioners who feel Congress will take action before then, and most predict that Congress is likely to decrease the exemption below $5 million. As such, it would be best to act now.

Other reasons to act now include:

  •     The estate tax rate may be higher and the exemption may be lower when you die.
  •     You can benefit your heirs while you are still alive.
  •     Future appreciation of the gifted assets will take place outside of your estate.
  •     Most states do not tax gifts, but most states do tax estates. In Massachusetts, an estate tax of up to 16% applies to estates exceeding $1 million in value.
  •     Some states, such as Florida, do not have an estate tax, but may decide to add one at some point. Transferring assets now will ensure that they are not subject to a future state estate tax.

Taxpayers can also take advantage of annual exclusion gifts, which allows gifts valued at up to $13,000 a year per beneficiary without being subject to gift taxes and is a way of transferring wealth without incurring gift tax that can be done in addition to gifts that take advantage of the lifetime exemption. There are also opportunities to make gifts that are not treated as gifts for gift tax purposes, such as making payments directly to qualified education institutions for tuition or to a provider of qualified medical expenses in payment of such expenses.

Congress also decreased the tax rate on gifts exceeding the exempt amount from 55% to 35%. For some ultra-wealthy clients who have already taken advantage of the $5 million lifetime gift exemption, paying gift tax at a 35% rate on gifts that exceed the lifetime exemption may still be a valuable planning opportunity given that such rate may be higher at a later date.

For several reasons, trusts are commonly used when structuring lifetime gifts. When a gift is made to a trust that is treated as a grantor trust to the donor for income tax purposes, the grantor, instead of the trust or beneficiary, is taxed on the income. This can preserve more assets for the next generation since the trust retains the assets that would otherwise be needed to pay the income tax. It is also not a gift to the trust for gift tax purpose when the grantor pays the income taxes. In effect, the payment of the income taxes on behalf of the trust is a tax free gift.

A married couple can retain limited access to the gifted assets without retaining the assets in their estate if the grantor's spouse is a beneficiary of the trust, which will help ensure that they have enough assets to live on, as long as such spouse is alive.

Some Issues to Consider

When structuring a lifetime gift, one unknown that should be considered is whether Congress will include a "claw back" in future legislation. A claw back would tax gifts made during the $5 million exemption period based on the exemption level that is in effect at the taxpayer's death, which could be much lower ($1 million for example) if Congress reduces the $5 million exemption.

The estate's beneficiaries would bear the tax liability from both the lifetime gifts and their transfer at death, if there is a claw back. Currently, when a taxpayer dies, lifetime gifts are included when calculating the estate tax exemption. Estate taxes are owed on any amount that exceeds the unused portion of the exemption.

This issue is especially important to consider when the lifetime beneficiaries are different from the remainder beneficiaries. Regardless, any appreciation in value between the date of the gift and the date of death remains outside the estate and is not subject to estate or gift taxes, even if there were a claw back. Prudent practitioners are therefore structuring estate plans to take advantage of the huge increased gifting and GST opportunities before they expire in the event there is no claw back, which many believe will not happen, and to also include flexibility in the plan to minimize or eliminate any negative tax impact in the event a claw back does occur. This type of planning gives taxpayers the ability to benefit greatly from this opportunity given that they will at least remove from the taxable estate what could be significant appreciation on such large amounts gifted, and reap more savings in the event there is no claw back.

Another important consideration when shifting ownership of assets that are likely to appreciate is whether the taxpayer is expected to have a long or short lifespan after the transfer. When a taxpayer passes an asset to a beneficiary during his or her lifetime, the recipient takes over the original person's holding period and cost basis assuming such is lower than the fair market value of the assets at the time of the transfer. That could mean a significant tax liability to the recipient upon realization of the gain.

Under current law, when a taxpayer passes an asset to a beneficiary upon death, the asset receives a step-up in basis to its fair market value at the date of death. As such, it may be best for the taxpayer to continue to hold onto assets that have already appreciated significantly and to allow the recipient to receive the increased basis upon the taxpayer's death, particularly if the taxpayer has a short life expectancy and does not expect significant appreciation between now and when he or she passes away.

Conclusion

It is important to discuss the current gift, estate and GST planning opportunities available with your advisors to make sure that your overall estate planning goals will be met, and that you plan as flexibly as possible to avoid potential pitfalls, based on the huge potential tax savings and limited time offer.



__________________

About the Authors

Stephen A. Colella, JD, CPA/PFS, MST is a principal in the Private Clients Group and Sarah Wulf, CPA is a Tax Manager at DiCicco Gulman and Company, LLP in Woburn, Mass.  Steve can be reached at scolella@dgccpa.com and Sarah can be reached at swulf@dgccpa.com.












]]> Stairway to Estate Planning Heaven tag:www.wealthstrategiesjournal.com,2011:/articles//8.6447 2011-11-29T22:20:27Z 2011-11-29T22:25:57Z Associate Editor - 3
Stairway to Estate Planning Heaven

By: Martin M. Shenkman, CPA, MBA, JD


Summary: Led Zeppelin's classic hit has remained popular with boomers as a paradigm for their estate planning. Rung by rung you can improve your tax and asset protection benefits by climbing upward towards estate planning heaven. We'll start at the bottom and work upward.

Father Knows Best Trust. 

     Coke classic might be great, but not Trust Classic. Most folks have used for a long time in their estate plans. These antiques typically mandate that income be paid out annually, name the beneficiary as a trustee, give the beneficiary in his capacity as trustee the right to distribute money to himself (often limited to an "ascertainable standard" - health, education, maintenance and welfare). Most of these trusts ) pay out trust principal at specified ages, say as 1/2 at ages 25, and the balance at 30.  Well, if you think wearing one of those Jim Anderson outfits is fresh, then this is just the type of trust you'd still want in your planning arsenal - Not!  If your trust is a model T, don't give up, you might be able to have the trust invest assets into a well crafted limited liability company (LLC) and create a new layer of control and protection. Other corrective steps might be possible. But this is not the kinda trust you want by choice.

Be a Paris Hilton Trust Fund Baby.  

     Hey being a trust fund baby ain't a bad gig if you can get it. But too often trust fund wannabes loose out 'cause their benefactors want their plans to be "simple," or they "don't want to rule from the grave." But if you have affluent parents or other benefactors (even a spouse or partner), even if you'll only get average gifts or bequests, they should be received by you in appropriately-structured trusts. A long term or perpetual trust, from which you can benefit and exert reasonable controls, should remain out of reach of your creditors, ex-spouse's and the Tax Man. To be effective this has to be planned before the property reaches you. The folks can get a simple will from a legal-whiz.biz website. It will be simple, and your malpractice claimants will thank them. If the folks don't want to "rule from the grave," what they'll really accomplish is limiting your flexibility. Good planning enhances the value of your inheritance and can be done with your input. That's not "ruling" its being prudent. If the folks don't want to deal with all this you can set up the trust yourself and just have mom bequeath your inheritance to the trust instead of you.  Gee that's so simple even a Congressman could even do it!

2011: A Trust Odyssey. 

     We hired HAL, Esq. to design your trust so it has the best provisions. Here's what HAL, Esq. recommended: A fully discretionary trust with no enforceable rights a ex-spouse, or malpractice claimant can enforce. You're named management trustee so you can have reasonable input. An independent trustee located in a jurisdiction with laws favorable to trusts (the Four Tops are: Alaska, Delaware, Nevada and South Dakota). An independent trustee makes all distribution decisions. The trustee can hold assets for your benefit, enjoyment and use. So that slick Airstream trailer can be owned by the trust, used by you, but out of the reach of creditors. The trust lasts as long as state law permits so that it can appreciate as long as possible outside of the reach of the estate tax and claimants, thus providing the same protections to your heirs. 

A Little DAPT will Do Ya'. 

     Who could forget the famous Brylcreem advertisement for Domestic Asset Protection Trusts! In most states you can't transfer assets to a trust, benefit from the trust, but keep your creditors at bay. Like the Brylcreem ad: "The creditors will all pursue ya,--They'll love to put their fingers through your hair." But a self-settled trust, created prior to a claim, in a state with favorable trust laws, may enable you to transfer assets that are protected from creditors after a statutory number of years. While there's no guarantees, and some risks exist (e.g., will other states respect the trust and transfers to it), many advisers are pretty confident that DAPTs will give your asset protection planning that the Brylcreem bounce. DAPTs, without more, aren't a tax save. They'll be included n your estate and are grantor trusts so the income is taxed to you.

Completed Gift DAPT. 

     The CGDAPT builds on the DAPT by your making the transfers to the trusts completed gifts. Giving up the control necessary to make the gift complete should remove the trust assets from your estate, saving estate taxes in the future. With the current $5 million gift exemption you can transfers a substantial amount of wealth to the DAPT. This can be followed by a sale of significant assets to the trust. This technique, a note sale to a grantor trust, may be one of the most significant ways to shift assets into a protective structure. If the value of the interests sold to the trust are discounted, further leverage and benefit is added. Your paying the income tax on earnings that remain in the trust burns assets in your estate while enhancing assets in the trust. But this party might last for long. The Democrats' wish list of revenue proposals surfaces as super-committee convenes include rolling the estate tax rules back to 2009 levels in 2012 instead of 2013. That might include a $1 million gift exemption which will take squeeze a lot of benefit out of complete gift transfers.

The "Have Your Cake and Eat it Too Trust". 

     In the DAPT or completed gift DAPT, you're the settlor establishing the trust and making transfers to it. Some advisers believe having another person, say a parent, set up the trust for you, makes the trust a safer structure from both a tax and asset protection perspective. If this approach is used, the trust will still need to be characterized as a grantor trust as to you. This is essential so that you can sell assets to the trust without triggering income tax. This is achieved by your having an annual demand power (Crummey power) to withdraw annual gifts the settlor (e.g., your parent) makes to the trust. That mechanism can provide the desired status. Thus, this trust is called a Beneficiary Defective Irrevocable Trust since it is a grantor trust (defective) as to you as beneficiary. When another person is the settlor establishing the trust you can have greater powers without jeopardizing the tax and asset protection benefits. Proponents maintain you can have the use and enjoyment of the assets purchased by the BDIT, the right to change the trust through a power of appointment, and not jeopardize creditor protection and estate tax savings. But as with many planning techniques, there are differing opinions on how far you can go. 

Insuring the Success or Your Trust Plan. 

     When Robert Plant crooned: "Ooh, ooh, and she's buying the stairway to heaven," he was referring to her purchase of a permanent life insurance policy inside the completed gift DAPT or the BDIT. If one of the assets inside these more sophisticated trust structures is an insurance policy a number of other benefits might be achieved. Insurance can provide for a tax free build up of growth inside the tax protective envelope of the insurance policy. With much talk about raising income taxes on the wealthy as part of the Budget Control Act's directive to reduce the deficit by $1.5 trillion, the new Medicare tax on passive investment income that takes effect in 2013, and other potentially costly changes, insurance may be further enhanced as a tax favored asset class. For many investors, the conservative returns of a cash value insurance policy might provide some offset to the risk in other portions of their portfolio. Importantly, if you die prematurely, before the tax burn which the grantor trust status has on your remaining estate can be felt, the insurance may cover the estate tax that would be due. It might be possible that if the trust owns life insurance the loan used in the sale of assets to the trust might fall within the ambit of the split-dollar life insurance loan regulations. If so, and the appropriate steps required under those regulations are adhered to, the characterization of the transaction as a loan for tax purposes might be assured. So insurance can enhance the income tax, estate tax, leverage and protection that the completed gift DAPT or BDIT might offer.

Conclusion. 

     Too many taxpayers are still using Jim Anderson archaic trust structures. But to find that stairway to estate planning heaven, more sophisticated and current trust planning techniques must be employed. The benefits you and your family could be tremendous.  Thanks to Dick Oshins, Esq. Las Vegas Nevada for his input.




]]> Resurrecting the $20-Million Estate: Don't Forget About the BDIT! tag:www.wealthstrategiesjournal.com,2011:/articles//8.6434 2011-11-26T05:31:36Z 2011-11-26T05:49:05Z Associate Editor - 3
Resurrecting the $20-Million Estate: 
Don't Forget About the BDIT!


Estates in the $10-million to $20-million range 
need to start planning immediately. 

Two limousines pull up alongside each other. The passengers roll down their windows. A bottle is exchanged. Is it Dom Perignon? Is it Grey Poupon? Or is it...Pepto Bismol? 

Worrisome economic times have humbled estates of all sizes. Even a once-mighty estate may now need to be nurtured back to fiscal health. 

As the estate tax prepares for a dramatic return in 2011, the challenge of estate taxation has returned as well. 

Let's review some of the best planning options for estates of about $20 million. One of those options is the Beneficiary Defective Inheritor's Trust (BDIT).

Meet John Dough

We pick up the discussion of a $20-million John Dough estate where we left off. The Dough estate, with many valuable homes and assets, has nonetheless been hit hard by the recession. 

Suddenly, instead of cruising along at $20 million with healthy income and solid equity growth each year, the estate has experienced severe shrinkage, has virtually no income, and jeopardizes its future by continuing to spend money like Nero during the last days of Rome. Making matters worse, any untimely demises of the Dough parents during 2011 under the automatic reversion to former estate tax rules would result in a huge estate tax burden. 

The nightmare scenario ends badly. What was $20 million and growing in 2007 has been diminished by several million dollars during the recession, is currently eroding by several million more, and could conceivably get chopped in half with an extremely unfortunate and unfair arrival of an estate tax from 2001 during 2011. The net result could be about $6 million being distributed among the four Dough children in 2011. Yes, things could be worse than leaving each child with $1.5 million. The results in the given hypothetical situation would probably work out better than that, even with poor planning. But for optimal results, the estate must get back on a growth track and have some methods for bypassing transfer taxes.

For example, if the estate can eliminate expenses and generate enough current income to just break even without liquidating significant assets, it will have an opportunity to recover and appreciate in value in the future. Many economic forecasts indicate rough patches in the near term and a longer term with sluggish growth, but, with so much national and international debt, there is a likelihood of heavy inflation in the future. 
Why is inflation anticipated? The United States has a national debt of $13.5 trillion at the moment. If the Treasury prints more money, the dollar will go down in value, prices will go up, and the $13.5 trillion will be easier to pay off. The United States will resist simply printing more money, but governments around the world facing the same problems will also be burning off debt with some inflation. Economic cycles come and go; when the next growth cycle arrives, there will be good reason to increase monetary supplies and stoke the fires of growth. Not all assets will benefit equally from inflation, but an estate with a number of valuable and diversified assets will grow significantly. 

As a rule of thumb, a 10% growth rate will double an asset's value in about seven years. A 7% growth rate will double an asset's value in about 10 years. So, for argument's sake, if a $20-million estate has shrunk down to $15 million or so currently, a 25-year projection with 8 years of slow growth, 7 years of heavy inflation, and then 10 years of moderate inflation could produce a magnificent estate. Let's say the $15-million estate spends the next eight years recovering and increasing back up to the $20 million it was worth previously. If that estate then has the benefit of heavy and then moderate inflation for periods of 7 and 10 years, respectively, it would then double to $40 million and then $80 million by 2035. 

A husband and wife who are age 50 now will turn 75 in 2035. If they have $20 million in assets now, experience growth as described, and simply earn enough other income to break even, they will have very large estates. If they inherit additional wealth or have significant wealth increases from careers or businesses, their estates will be even larger. These are estates that will undoubtedly incur transfer taxation in the future. 
By transferring these assets currently, while they are diminished in value and long before the waves of inflation cause their value to recover and then double and redouble, the assets will avoid the heavy transfer taxes that would apply to them in the future. 

The BDIT Option

There are a number of estate-planning approaches that freeze the value of assets for estate planning purposes or protect assets from creditors, but let's focus on a relatively new idea that compares well to other techniques. 

Inheritors' trusts have been discussed and vetted for the past decade. But it may take a while for novel solutions to filter down into everyday usage--and the BDIT may have become associated with the largest of estates--but even a relatively moderate estate of $8 to $10 million can use a BDIT to great advantage. When scrutinized closely, the BDIT has many elements that are tried-and-true staples of estate planning built right into it, raising the comfort level for employing this approach. And a smaller estate of $10 million that really can't contemplate other alternative estate planning techniques that lose control and benefits of assets can take full advantage of a BDIT. Let's review.

"Intentionally defective" is a misnomer, in that it's an approach taken to direct tax liability to the most strategic person or entity. 

The Inheritor's TrustTM concept of transferring assets to a trust established by a parent is not brand-new by any means, and the Beneficiary Defective Inheritor's Trust (BDIT) is simply a variation on that theme. It utilizes the same approach as any Intentionally Defective Grantor Trust (IDGT) that enables income to be taxed to the grantor. 

An IDGT is designed to be "intentionally defective," i.e., in violation of grantor trust rules. Trust income can be accumulated or paid to the beneficiaries, but it is taxed to the grantor of the trust, thus further reducing both the size of the remaining estate that the grantor would need to transfer and the applicable transfer taxes. 

The same concept applies to a client who sets himself up as a beneficiary of an Inheritor'sTrust. The trust is drafted so as to treat the beneficiary (the client) as the owner of the trust for tax purposes, i.e., defective beneficiary status for income tax purposes but not for estate tax or creditor purposes. This can be accomplished in various ways. One simple approach is by providing the beneficiary with Crummey-style withdrawal powers under IRC §678(a). 

The biggest difference between an IDGT and a BDIT is that the BDIT involves an Inheritor's Trust that is created by a third party, so the client becomes a beneficiary and trustee of the trust rather than a grantor. This means greater control and use of the trust assets for the client than with a traditional IDGT, in which the client cannot be the beneficiary. 

With that premise, the client (i.e., the beneficiary of the trust), can even have power to modify the trust in the future. The client may not only be the trustee, but he or she can also have broad powers of appointment to rewrite key provisions of the trust to adapt to changed circumstances. An irrevocable grantor trust that provides the grantor with too much power risks having the entire trust invalidated. 

Traditional trusts that transfer assets downstream have some disadvantages, in that the grantor can't also be a beneficiary in most jurisdictions. A self-settled trust attracts the scrutiny of creditors and the IRS. By comparison, a trust established by the client's parent does not have this issue. 

Unlike traditional downstream trusts, the Inheritor's Trust looks upstream to take better advantage of assets that the client has not yet inherited. A parent of the client sets up the trust as a grantor, and the client can then sell additional assets to that trust. 
Intercepting an inheritance and directing it into a separate trust before the assets can be received by the client's estate has impressive advantages. The funds are directed in anticipation of what the client would have done. The client exercises great influence over the funds under the terms of the trust. Yet the assets, having never belonged outright to the client, avoid exposure to debts and liabilities. 

An Engine of Wealth

The Inheritor's Trust can take on a life of its own: Once a pool of assets arises, it can be invested in businesses, life insurance, or other assets. 

If the client has an existing asset when setting up an Inheritor's Trust, he can sell that asset to the trust now when the value is relatively low and take back an installment note. Another party, such as the client's spouse, can guarantee the note. As an alternative, an irrevocable life insurance trust can be used to guaranty the note. By selling a business or other wealth-earning opportunities to the trust at its inception, future earnings and appreciation of the assets are kept out of the client's estate. 

Over time, the growth of the trust creates a separate pool of assets to use as seed money in several contexts. Businesses and investments can take shape within the trust without ever being exposed to the divorces, creditors, and personal liabilities that would otherwise apply.

Life insurance is often suggested as part of several estate planning techniques. Life insurance can provide a source of liquid assets to pay estate taxes or can be an instant asset that is not included in the decedent's taxable estate because it was purchased and owned by a separate irrevocable trust. The Inheritor's Trust is positioned in the same way and can purchase life insurance on the client's life without the proceeds being included in the client's gross estate. 

The Inheritor's Trust can become the 1% general partner of an FLP. A relatively small amount of assets is needed; if the funds are derived from a separate source, i.e., anyone other than the client, the trust will retain the controlling interest. The client could retain control over the FLP in a fiduciary capacity on behalf of the trust, yet his or her estate would only possess noncontrolling interests in the FLP.  

As with any well-designed trust, once an Inheritor's Trust is up an running with a trustee and other professionals administering assets, it can handle any number of arrangements. So an Inheritor's Trust can be coordinated with a generation-skipping GRAT, a buy-sell arrangement for buying out a business, state-income tax strategies, and many other techniques in an array of useful variations. See Oshins, Alexander, and Simmons, The Defective Beneficiary Inheritor's Trust: Finessing the Pipe Dream, CCH (2008).

BDITs for Moderate Estates

We often associate relatively new estate planning techniques with ultra-large estates, but the Inheritor's Trust and the BDIT variation of it make good sense for moderate estates, including the $20-million size we've been discussing, estates in the $8- to $10-million range, or simply the estate of a professional with a high-income career track, such as a physician, attorney, business owner, or executive. 

As opposed to someone with $50 million or $100 million, who can afford to part with substantial amounts of wealth, someone with $10 million can't really part with wealth. A BDIT provides a "have cake and eat cake" solution, in that the client can move assets into a trust and a) retain control over the assets as trustee, b) retain income from the assets as a beneficiary, and c) do all without being considered the grantor. Moreover, these installment-sale transfers to the BDIT will not use up the client's other lifetime gifting and generation-skipping exemptions.  

Comparing Techniques

Richard Oshins, who has worked on the Inheritor's Trust concept for many years, recently compared the BDIT variation of the Inheritor's Trust with a number of other popular approaches with the moderately sized estate in mind. 

FLP v. BDIT: Family Limited Partnerships provide a freeze of values and discounting of values for assets transferred to the FLP, while maintaining control by the business owner. The same benefits are provided by a transfer of business assets to a BDIT. The difference, however, is that the IRS is constantly trying to treat FLP transfers as running afoul of section 2036 and including the transferred assets in the grantor's estate, whereas a transfer to a BDIT is never treated that way. 

       IDGT vs. BDIT: A sale of assets to an Intentionally Defective Grantor's Trust (IDGT), in return for a note, is an approach favored by some; however, when business assets are transferred, the grantor has to retain shares of the business to maintain control, which has estate tax implications. By comparison, a note sale to a BDIT can occur without any strings. The client can transfer the asset and let go of it because he or she will then retain control over it as trustee of the BDIT. The client also retains the use and benefit of the transferred assets as a beneficiary of the trust. There are strategic uses for special power of appointment that can be applied with this approach as well.
       DAPT vs. BDIT: A Domestic Asset Protection Trust (DAPT) is typically designed to take advantage of one of the 13 state jurisdictions within the United States that allow some variation of self-settled trusts. These DAPT jurisdictions have various exceptions and waiting periods. The shortest of the waiting periods is two years for Nevada and Hawaii. By comparison, the BDIT takes effect immediately. It should also be noted that, other than Nevada, most asset protection trust jurisdictions limit the settlor's control and do not automatically provide tax savings. By comparison, the BDIT provides the client with control as the trustee and provides tax savings by removing assets and their future appreciation from the client's estate. Foreign asset protection trusts also have limitations on control and involve continuous expenses.

ILIT vs. BDIT: The Irrevocable Life Insurance Trust is a classic arrangement that keeps assets out of the grantor's estate. An irrevocable trust is set up, and Crummey transfers are made to the trust each year. The trust purchases and owns life insurance on the grantor. The life insurance proceeds are not taxed in the grantor's estate. A BDIT can simply purchase life insurance on the client's life without the proceeds being included in the client's estate. An independent special trustee would be used to own the insurance for this option. The same benefits as an ILIT are obtained but without the Crummey transfers and record keeping. 

Gifting vs. BDIT: The simplicity and immediate gratification of a gift is attractive, without a doubt. Clients can utilize the annual gift tax exclusion and the lifetime exemption of $1 million to move assets from the client's estate to that of a beneficiary. On the other hand, assets transferred to a BDIT can then be used by the same beneficiaries, with the permission of the client in his or her capacity as trustee. The assets remain in the BDIT and are protected from creditors. None of the clients gifting exemption is exhausted by use of the BDIT. 

Revocable Trusts vs. BDIT: The revocable living trust provides management control during life and probate avoidance at death. The BDIT provides just as much control and avoids probate just as well. The difference is that the BDIT also provides transfer tax savings and lifetime asset protection. The revocable living trust remains accessible to the grantor's creditors during life and is included in the grantor's taxable estate at death. 

QRP vs. BDIT: A Qualified Retirement Plan can provide a buildup of tax-deferred assets. By comparison, life insurance inside a BDIT can provide tax-deferred growth without the complexities of retirement plan administration, mandatory employee coverage, required minimum distributions, and income in respect of a decedent. Meanwhile, the cash value of the life insurance is accessible to the insured beneficiary thanks to an independent trustee.

Conclusions

For the moderate estate in the $8- to $20-million range, the BDIT approach can provide a combination of control, income, creditor protection, and transfer tax savings that is straightforward and well organized. With the return of the estate tax, there is now more motivation to consider this approach than ever. 







]]> The Reasonableness of Owners' Compensation: An Often Overlooked But Key Assumption in Valuing a Business tag:www.wealthstrategiesjournal.com,2011:/articles//8.6430 2011-11-22T16:35:21Z 2011-11-22T16:46:06Z The Reasonableness of Owners' CompensationAn Often Overlooked But Key Assumption in Valuing a BusinessBy: Jesse A. Ultz, CFAMany business owners are motivated to deviate from an arm's-length compensation level for owners in order to minimize taxes paid either at the... Associate Editor - 3
The Reasonableness of Owners' Compensation

An Often Overlooked But Key Assumption in Valuing a Business

By: Jesse A. Ultz, CFA


Many business owners are motivated to deviate from an arm's-length compensation level for owners in order to minimize taxes paid either at the corporate or individual level. For example, owners of businesses organized as C corporations may be incentivized to pay owners' compensation above that of an arm's-length amount in order to minimize taxes incurred at the corporate level. In contrast, owners of pass-through entities, such as S corporations, may be motivated to pay reduced compensation to owners and instead make distributions to owners in order to avoid payroll taxes. FN1. Given these strategies, the Internal Revenue Service (the "IRS") requires that, to be recognized as a business expense based on §162(a)(1) of the Internal Revenue Code (the "Code"), compensation must be reasonable in amount and must be paid "for personal services actually rendered." Moreover, shareholders of private businesses have the burden of proof when evaluating what is reasonable as it pertains to owners' compensation. Treas. Reg. §1.162-7(b)(3) defines "reasonable" compensation as the amount that "would ordinarily be paid for like services by like enterprises under like circumstances." For any closely held business that has either significant reasonable or actual owners' compensation relative to overall earnings, the adjustment to that of an arm's-length transaction may have a profound impact on the concluded value.

Guidance from Case Law

Due to the influence of the Code on compensation, the IRS has a long history of dealing with reasonable compensation issues in Tax Court and on appeal. As such, Tax Court cases can provide guidance in reviewing the reasonableness of compensation for executives who are also owners.

An example of an IRS challenge to reasonable compensation is Menard, Inc. and John R. Menard, Jr. vs. Commissioner, which reached the Seventh Circuit Court of Appeals (the "Seventh Circuit"). In 1998, the tax year at issue, Menard, Inc. (commonly referred to as Menards), was the third largest retail home improvement chain in the U.S., behind only The Home Depot, Inc. ("Home Depot") and Lowe's Home Centers, Inc. ("Lowe's").

John R. Menard, Jr. founded the company in 1962 and served as the chief executive officer in 1998. He worked approximately 12 to 16 hours per day and six to seven days per week. He was involved in every aspect of the company's management and took minimal vacations every year. During his tenure as CEO between 1991 and 1998, the company's revenue increased from $788 million to $3.4 billion, as taxable income increased from $59 million to $315 million. In addition, in 1998 the company generated an 18.8% return on equity (higher than both Home Depot and Lowe's during the same year). Mr. Menard, who owned all of the company's voting shares and approximately 56% of the nonvoting shares, paid himself a modest base salary but participated in the company's bonus program and profit sharing plan. The IRS challenged his compensation, arguing that his profit sharing compensation was more like a dividend than compensation, which allowed the company to deduct a greater amount of salary expense, while allegedly escaping the corporate-level tax.

The Tax Court considered whether the following factors were present with respect to the structure of the compensation plan for Mr. Menard in determining reasonable compensation:

  • Bonuses were paid in exact proportion to the officers' shareholdings
  • Payments were made in lump sums rather than as the services were rendered
  • Formal dividend distributions were absent even as the company was expanding
  • Bonus systems were unstructured or lacked relation to services performed
  • The company consistently had negligible taxable corporate income
  • Bonus payments were made only to the officer-shareholders

Additionally, the IRS considered the compensation of executives at comparable home improvement retail companies, such as Home Depot and Lowe's, as a basis for its argument. Effectively, the IRS employed a multi-factor test in determining reasonable compensation. That is, it utilized various qualitative factors in comparing the compensation of Mr. Menard vis-à-vis peers at comparable companies. The Tax Court agreed and opined that Mr. Menard's compensation was largely a disguised distribution.

In its review of the Tax Court opinion, the Seventh Circuit commented that the following factors, often included in a multi-factor test, were "semantic vapors," and wholly subjective:

  • Type and extent of the services rendered
  • Scarcity of qualified employees
  • Qualifications of the employee
  • Employee's contributions to the business venture
  • Peculiar characteristics of the employer's business

In its review, the Seventh Circuit commented on the long hours Mr. Menard worked as well as the size, growth, and profitability of the company. Additionally, the Seventh Circuit commented that Mr. Menard's bonus program, which entitled him to receive 5.0% of the company's earnings before income taxes, was neither excessive nor a scheme to avoid paying certain taxes because:

1) the company generated a return on equity in excess of its peers even after consideration of the bonus

2) the bonus was conditional on the company generating income

3) the bonus was paid as a percentage of income

Dividends are generally paid as a specific dollar amount, with the intention that the investor receives a more predictable cash flow. A bonus, like the one offered to Mr. Menard, was riskier in nature and was offered to a manager to align his incentive to that of the firm, even if the manager was also a shareholder. The Seventh Circuit additionally commented that for compensation purposes, the shareholder-employee should be treated like all other employees. As such, a shareholder-employee should be treated as two distinct individuals for tax purposes (i.e., an independent investor and an employee), especially as it relates to compensation structure. Effectively, the Seventh Circuit advocated an independent investor test in assessing the reasonableness of owners' compensation.

An example of the independent investor test was previously applied in Exacto Spring Corporation v. Commissioner, which was summarized by the Seventh Circuit as follows:

"A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner's investment. The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid, for it will be implausible that if he quit if his salary was cut, and he was replaced by a lower-paid manager, the owner would be better off; it would be killing the goose that lays the golden egg."

In short, seemingly exorbitant compensation may still be reasonable if management outperforms and delivers the high rate of return investors expect given the risk of the investment.

Although this case was not the first to embrace the independent investor test, the Seventh Circuit did break with precedent in viewing this test as distinct from the multi-factor test. In describing the distinctiveness of the new test, the Seventh Circuit claimed "the new test dissolves the old and returns the inquiry to basics."

However, the independent investor test still inherently involves opinions as to appropriate expected rates of return, the degree of return attributable to management, and the appropriate compensation to be paid to management for its contribution. Still, the independent investor test has, at a minimum, appropriately noted that compensation in order to align interests in maximizing returns can be significant. The test exists in practice by many public corporations that compensate upper management handsomely in conjunction with stock price performance. Both tests require empirical evidence in making assessments and comparisons.

Determining Reasonable Compensation

When valuation professionals need to assess owners' compensation, case law suggests three separate analyses that may be considered.

1 Direct Test (Market Databases)

Compensation databases and surveys report the ranges of market compensation paid for numerous job titles based on industry, organization size, and geographic location. Accordingly, these surveys provide analysts with empirical data regarding the market wages of executives. To properly utilize this information, however, an analyst must have a detailed understanding of the sources of the data, its timeliness, and its applicability to the subject company.

A key issue in determining reasonable compensation is identifying the appropriate roles and responsibilities of the individual in question. Many of the highest paid employees of privately held companies have roles and responsibilities that cannot easily be condensed into a single job title, even if their given title may directly match one found in the database. In other words, while the subject individual in a reasonable compensation case may have the title of chief executive officer or president, a detailed understanding of his/her actual duties is necessary to ensure that the scope of his/her corporate responsibilities does not exceed (or fall short of) the assumed responsibilities ascribed to the corresponding title in the database. Oftentimes, valuation professionals may need to analyze the compensation data for several job titles in order to appropriately determine the market compensation level for the individual at hand. Given that many business owners wear numerous hats within their company (e.g., CEO, director of corporate development, lead salesperson, etc.), it is critical to match the value being provided by the owner to the value being provided by the employees referenced in the studies.

After gaining a thorough understanding of the subject individual's roles and responsibilities and conducting a careful search for the associated titles in the compensation databases, a valuation professional may conclude on a reasonable range of compensation for the individual in question.

2 Market Ratio Test (Comparable Public Companies)

Valuation professionals may also consider using market ratios to determine reasonable compensation. Publicly traded companies are required to disclose the compensation of certain corporate officers. By analyzing total executive compensation (i.e., both cash-based and share-based) of comparable publicly traded companies, a valuation professional may develop a range of compensation (as a ratio of revenue and/or earnings) that the market deems reasonable for that particular industry.

Because macroeconomic trends and industry fluctuations can result in significant variability in compensation ratios, a detailed understanding of the market in general and the industry in particular is required to fully utilize this methodology. Additionally, the significance of this analysis can be limited by the comparability of the subject company to publicly traded companies and the amount and quality of information related to executive compensation disclosed by the selected companies. Nonetheless, the market ratio test can provide a valuation professional with a range of ratios with which to assess the reasonableness of owners' compensation.

3 Shareholder Return Test (Management Value Creation)

A third method of assessing the reasonableness of an individual's compensation is the application of the shareholder return test. As the Menards and Exacto Springs judgments show, the shareholder return generated by a company under an executive's leadership must be considered when assessing the reasonableness of compensation. Comparing a subject company's equity appreciation over the period of time in question to the appreciation of comparable publicly traded companies yields valuable insights into the relative performance of the company and the associated returns achieved by shareholders.

If a company's earnings (after consideration of the actual executive compensation) generate shareholder returns that are at or above market levels, an independent investor may accept the owners' compensation as reasonable. While this quantitative analysis should be supplemented with qualitative evidence that the excess returns are attributable to the individual in question, the shareholder return test can provide valuation professionals with evidence that the company is able to satisfy the independent investor test while sustaining the current level of executive compensation.

Conclusion

When used in conjunction with one another, the three tests discussed above allow valuation professionals to develop supportable estimates of reasonable compensation. The conclusions developed from the use of these methods will be based on empirical data, supported by public capital markets, and, most important, will meet the standards of reasonable compensation put forth by the Tax Court. Given the potential tax repercussions resulting from inaccurate assessments of owners' compensation, the issue of reasonable compensation should be carefully considered by owners and their advisors.

______________________

FN1 The benefits of each respective scenario could be more or less lucrative given the ownership interest held by an executive and the differences between the ordinary income tax rate and dividend tax rate.






]]> The Cain Plan v. The Able Plan: An Empirical Analysis tag:www.wealthstrategiesjournal.com,2011:/articles//8.6408 2011-11-17T13:09:57Z 2011-11-17T13:17:45Z THE CAIN PLAN v. THE ABLE PLANAn Empirical AnalysisBy: Nick Paleveda, MBA, JD, LLMThere is no question that the Herman Cain tax proposal 9-9-9 has gained recent traction in the media primarily to the simplicity of the proposal and... Associate Editor - 3
THE CAIN PLAN v. THE ABLE PLAN
An Empirical Analysis


There is no question that the Herman Cain tax proposal 9-9-9 has gained recent traction in the media primarily to the simplicity of the proposal and the catchy wording. In this article a brief empirical analysis of his proposal will take place as the plan is brief and further analysis may be reached dianoetically.

The Economist Arthur B. Laffer

The economist Arthur B. Laffer stated, "Herman Cain 9-9-9 plan is...to right the wrongs of our federal tax code." But is this true? The Internal Revenue Code "Flesch score" (a readability of a document) was performed along with the Sunday comics and Newsweek. The comics had a score of 90 (very readable), Newsweek had a score of 50 (need some education) and the internal revenue code negative six (impossible). This indicates an obvious wrong where understanding the tax code can be a challenge for any person reading the code and regulations. Mr. Laffer went on to state," For every dollar of business and personal taxes paid, some 30 cents in out of pocket expenses are also paid to comply with the tax code". Laffer offers no support for this statement, however the National Taxpayer Advocate latest annual report in 2008 states the cost of compliance reached an all time high of $163 billion or 11% of aggregate receipts. The 30% figure is currently unsubstantiated.

Laffer went on to conclude, "Once the dynamics take hold, many of those below the poverty line will find good jobs and thus rise above the poverty line and start paying taxes." Once again here is no substantiation for the position or no analysis why poor people will automatically become successful once more of the tax burden is shifted to them by imposing higher taxes including income and a new national sales tax. Mr. Laffer also went on to state: " and this 9-9-9 plan has made certain that even in static terms those below the poverty line will be better off-period." Once again the statement calls for a conclusion without any supporting analysis. Mr. Laffer can offer no plausible explanation why increasing taxes for people below the poverty line will make them better off.

The problem with 9-9-9 is it appears to be designed by Mr. Cain to help Mr. Cain's own personal tax situation or is the result of unconscious cerebration. The plan appears to be egocentrically drafted for example:

1. New National Sales Tax of 9%

Mr. Cain is 65 years old not 25 years young. Most of his purchases, cars, homes, boats have already been made. Hence the burden of the new national sales tax will be placed on young people who have not acquired cars, homes, furniture, boats etc. Mr. Cain will probably not be concerned with this new national sales tax.

2. Corporate Tax of 9%

Mr. Cain has left corporate life so this tax will probably not affect him. However small business owners the "true job creators" of the last decade who generally can zero out their corporate taxes will now feel the bite (depending on which Cain you talk to the tax is on the gross billings or net profit). For example, a company with one million in revenue will pay $90,000 in corporate tax. Many small businesses will go under in this tabescent economy if the Cain plan is passed. This tax is a gross tax that like the one that exist in Washington State known as the B+O tax. The tax placed on Gross Receipts. In any event it will not be Cain's pain.

3. 9% Personal Income Tax

Once again no tax to Cain as most of his income is "capital gains or dividends". Everyone one else will feel the pain of this tax especially people in poverty where Cain was quoted as saying "They will learn to stretch their dollars further". Interesting. The Cain household will be basically exempt where other households will have to learn to "stretch their dollars further". Assuming Cain's net worth is 18 million as reported and he collects 5% in dividends and capital gains on his net worth, his income will be $900,000 and pay no tax. A worker making $10.00 an hour or $20,000 a year will pay $1800.00 and a person in poverty at $10,000 a year will pay $900.00 under the Cain proposal.

The Cain proposal is also to eliminate estate and gift taxes which will further prevent him and his family from having to pay any tax whatsoever. In the Final analysis, the Cain 9-9-9 plan is really a fugacious ME-ME-ME plan. So what proposal would work?

The ABLE 9-9-9 PLAN.

The Able plan is also a simple plan, but it is designed to shift the tax burden away from working people and true job creators and onto the "faux job creators". A pleasant myth exist that high net worth individuals create jobs where in fact some do create businesses and jobs and some do not.

1. 9% Net Worth Tax

First, eliminate the "payroll tax of 15.3% (now 12.4%) for workers who are really the backbone of the American economy and "true job creators". These small and large businesses are responsible for true job creation. Replace the tax with a "net worth tax of 9%. Cain will now feel the "pain" as he would owe $1,620, 000 on his 18 million dollar estate. Perhaps he would have to "learn to stretch his dollars further".

2. 9% Capital Gains and Dividends tax

Second-eliminate the income tax from income on an "active trade or business" and replace it with a "capital gains and dividends tax". Now Cain would pay $81,000 on his $900,000 income as opposed to $0.00.

3. 9% Estate and Gift Tax

Third replace the corporate tax with a 9% Estate and Gift Tax. Now the real job creators, small business and large business alike will have a break as they are the real jobs creators and he people who amass large fortunes by inheritance will have to pay a tax as opposed to paying nothing which is the Cain plan.

Conclusion: The Able plan is also 9-9-9 but rewards workers and small and large businesses where the Cain plan is not Able to do this at all. If any deficits occur to the Able plan, we exercise our right to print money to fill the gaps as we did under the Legal Tender Act of 1862. Although Cain's idea to think outside of the box is admirable, the empirical conclusion is that it was egocentrically drafted and the conclusion that jobs will be created as purported by Mr. Laffer is unsubstantiated.










]]> Avoiding a GSTT Asteroid tag:www.wealthstrategiesjournal.com,2011:/articles//8.6368 2011-11-07T21:07:08Z 2011-11-07T21:15:15Z Associate Editor - 3
Avoiding a GSTT Asteroid FN1

Revisiting a Dangerous Adversary: 
The Generation Skipping Transfer Tax


"It hit with the force of 10,000 nuclear weapons. A trillion 
tons of dirt and rock hurtled into the atmosphere, creating 
a suffocating blanket of dust the sun was powerless 
to penetrate for a thousand years. It happened before. 
It will happen again. It's just a question of when."
--From Armageddon (1998), a motion picture starring Bruce Willis, 
in which an asteroid heads toward planet Earth. FN2.  

The odds that an estate will run afoul of the generation skipping transfer tax (GSTT) may be rather slim nowadays, but estate planners must never let down their guard against this virulent adversary. 

The GSTT sneaks up without warning and packs a powerful punch. Just the convoluted process of calculating this tax can send an estate planning professional into a black hole of despair. 

Let us review GSTT rules and strategies. But first, to set the GSTT in proper context, we must travel back through the time-space continuum to a more innocent time, before the GSTT existed, when the estate tax was the primary opponent for estate planning.  

The Kennedy Fortune 

Joseph P. Kennedy (1888-1969) was the president of a bank at age 25. He boldly invested during the Roaring Twenties and was a master of stock market manipulation and insider trading before such practices were regulated. He became a millionaire by age 30 and had the instinct to sell his stocks before the Great Crash of 1929. He then used short sales to make huge profits during the Great Depression. Ironically, Kennedy later became the first Chairman of the Securities and Exchange Commission. 
Other fortunes were made in Hollywood and in real estate. There are rumors that Kennedy had a bootlegging operation, but this may be exaggerated considering Kennedy's foresight in cornering the market on importing legitimate pre-Prohibition alcohol. 

The net result was one of America's great fortunes. By 1935, he had amassed $180 million, the equivalent of $2.8 billion today.

Pre-GSTT Planning

During the years of Joseph Kennedy's peak wealth until his death in 1969, the estate tax had a top rate of 70% or 77%. It was a harsh gatekeeper that applied to every generation. From 1941 on, the 77% top rate applied to assets exceeding $10 million. If taxed at that rate at Joseph Kennedy's death, and then again only one generation later, the Kennedy fortune would have been erased. 

Kennedy saw the wisdom of avoiding a 77% tax. By passing wealth directly to his grandchildren, he skipped an entire layer of estate taxation.

For example, trusts that Joseph Kennedy established for John F. Kennedy provided JFK with income for life, as well as the right to withdraw up to 5% of principal in any year. During the Kennedy administration, the President's trust funds were said to be paying him $500,000 in annual income. Because Joseph Kennedy gave only a life estate to his son, the assets were not subject to estate tax at JFK's death. Thus, the government taxed the assets only once, in Joseph P. Kennedy's estate, before those assets reached Joseph's grandchildren, John F. Kennedy, Jr., and Caroline Kennedy Schlossberg.

The Kennedy estate plan shows that when assets are unencumbered by transfer taxes or the need to benefit one particular generation, the family can productively invest those assets in long-term pursuits. The Kennedy trusts held assets ranging from businesses to real estate. The family holding company, Joseph P. Kennedy Enterprises, contained the Merchandise Mart in Chicago, which Joseph Kennedy purchased in 1945 for $13 million and which was eventually sold for $625 million. 

The Next Generation: Camelot 

At the time of his assassination in 1963, President John F. Kennedy left a 1954 will that made no provision for his children. Had he lived, he might have adopted a multigenerational trust approach in the same manner as his father.

For the same reasons, it made sense for the President's widow, Jacqueline Kennedy Onassis, to direct her wealth to her grandchildren. She coordinated her GSTT strategy with a charitable lead trust (CLT) that would have reduced taxes and maintained privacy. 
Ironically, the public identified the Onassis estate with the use of CLTs, even though the estate's executors ultimately decided not to fund the trusts, demonstrating the flexibility of the Onassis estate plan. One reason for the change may have been the size of the estate, which fell short of the $100-$200 million amounts noted in the press, even with $34.4 million from a 1996 Sotheby's auction of the Kennedy family's personal property. On the other hand, the acclaimed CLT/GSTT arrangement may have resulted in too much GSTT after all.

Deep Impact: The First GSTT 

An entire generation of estate planners has never known a time when the GSTT did not exist. Travel back 35 years to a pre-GSTT age of innocence when Congress first began to sow the seeds of change. 

The summer of 1976 was a bicentennial time of tall ships and fireworks. In North Carolina, 5'8" Larry Jordan was beating his little brother Michael in one-on-one in the backyard. On Wall Street, the formation of Kohlberg Kravis Roberts and Drexel Burnham Lambert presaged a future era of hostile takeovers and junk bond deals. Silicon Valley did not yet exist. Steve Jobs, a 21-year-old college dropout, had just started Apple Computers in a garage, one year after 19-year-old college dropout Bill Gates founded Microsoft.

A typical estate planning lawyer might have spent the summer of 1976 musing over the latest Clifford trust techniques and pecking out letters on an IBM Selectric typewriter. 
Suddenly, a screaming comes across the sky.3 It is October, and the Tax Reform Act of 1976 has reached President Gerald Ford's desk. A meteor shower of tax changes unifies estate and gift taxes, increases the marital deduction, provides throwback rules for accumulation distributions from trusts, and makes other profound changes in the transfer tax system including the birth of a new tax, the first GSTT.

A Fallible Authority 

Congress makes mistakes. Tax experiments go awry. Lawyers take for granted the stepped-up basis for assets held at death under Code §1014. Nevertheless, in 1976, Congress attempted to impose carryover basis at death, only to postpone it and ultimately retroactively repeal it (and with quite a low profile) in the Crude Oil Windfall Profit Tax Act of 1980. It was as if the whole messy chapter was just erased, like the 1985 bad-dream season of Dallas. Forgetting this lesson, Congress dabbled with the carryover basis in 2010 and once again cleaned up the mess with a retroactive wipe down of its fingerprints. 

Likewise, problems soon became apparent with the first GSTT. For example, instead of a flat tax rate of 55%, Congress imposed the tax at the tax rate of the deemed transferor--the grantor's child or some other member of the generation that was skipped. To calculate the tax rate, the tax return preparer needed to know the size of the deemed transferor's taxable estate, including prior adjusted taxable gifts. This proved to be highly infeasible.

Due to this and numerous other problems, Congress first postponed the 1976 GSTT, amended it three times, and ultimately repealed it retroactively 10 years after the fact. In 1986, Congress provided an entirely new GSTT law. Codes §§ 2601-2663 comprise the 1986 GSTT. Here are five key points about that version of the GSTT.

1. The GSTT did not have a progressive rate schedule. Rather, Congress imposed the tax on nonexempt property at a flat 55% rate.

2. Each person had a GSTT exemption of $1 million, subject to adjustment for inflation.

3. A gift or bequest skips a generation when assets pass to an individual who is two or more generations below the transferor.

4. In the case of unrelated individuals, a transfer generation skips under Code § 2651(d)(2) if assets pass to an individual who is more than 37.5 years younger than the transferor.

5. Each generation is considered to be 25 years.

The current version of the GSTT is similar but has an exemption of $5 million and a tax rate of 35%. If only it were this simple.

The X Files 

Just to keep things interesting, there are several distinct types of generation-skipping transfers subject to the GSTT, each with its own horrendous and paranormal tax implications. A transfer in trust may not result in immediate GSTT. As circumstances unfold, however, a taxable termination or distribution in the future may involve skip persons and may trigger GSTT without triggering additional gift or estate taxes. By comparison, direct skips arise in a more straightforward fashion, i.e., when a direct transfer to a skip person triggers gift or estate taxes, as well as GSTT.

* Taxable terminations. Assume that a testamentary trust provides a life interest for Son with the remainder to Grandchild. At Son's death, his intervening trust interest ends and the only remaining trust beneficiary is a skip person, Grandchild. This results in GSTT liability to be paid by the trustee out of the transferred assets. See Code §2612(a)(1) and Code §2603(a)(2). Considering the 35% estate tax that Grandparent's estate paid, the additional GSTT on the remaining assets brings the effective tax rate on the gift to Grandchild up to about 58%. 

* Taxable distributions. A testamentary trustee's discretionary distribution from a spray trust to a skip person results in GSTT liability to be paid by the skip person and effectively reduces the transferred amount. Code §2603(a)(1). Treas. Reg. §26.2612-1(C)(1) treats the trustee's payment of GSTT as a taxable transfer subject to additional GSTT. What happens if the transferor pays that tax as well? Will there be a gift tax on a GSTT tax after an initial estate tax? With higher rates in the past, this resulted in confiscatory tax rates exceeding 100%. Nowadays, with lower rates, the impact is merely brutal, exceeding 75%. 

* Direct skips with tax payment. Grandma makes a direct transfer to Grandson. It is a taxable gift with no exclusions. Grandma pays the gift tax. Grandma also pays the GSTT. Grandma's payment of the GSTT is treated as an additional taxable gift. One transfer, three tax hits. 

* Adding to GSTT-exempt trusts. Never, never do this. A trust that is otherwise exempt from GSTT consequences can become exposed to GSTT consequences if it receives a generation skipping transfer. Separating trusts into GSTT-exempt and non-exempt is an effective strategy, however.  

GSTT Strategies

Reverse QTIPs. Clients and their lawyers should not overlook the grantor's GSTT exemption by transferring all assets to a surviving spouse. If a "reverse" QTIP election is made under Code § 2652, those assets will remain in the deceased spouse's estate for purposes of claiming the $5 million GSTT exemption. Because that election applies to an entire QTIP, a client should use two separate QTIP trusts to make the reverse QTIP election for one of the trusts and use the grantor's GSTT exemption, while the other QTIP remains in the surviving spouse's estate for GSTT purposes. That way, the surviving spouse's GSTT exemption can also be used. The resulting alignment of three trusts looks like this: 

Trust #1: A credit shelter trust to which the grantor's executor allocates GSTT exemption.

Trust #2: A separate QTIP trust to which the grantor's executor allocates the grantor's GSTT exemption remaining after allocation of the exemption to the credit shelter trust and with respect to which the executor makes a reverse QTIP election.

Trust #3: Remaining assets in a standard QTIP trust to which the surviving spouse's GSTT exemption will be allocated at his or her death.

* Anti-GSTT approaches. A client should use intervening generations when appropriate. If the client exhausts his or her GSTT exemption and plans to skip a generation by leaving assets to a grandchild, this will actually produce a higher tax. The client should consider the alternative of not skipping a generation and leaving assets to a child, in whose hands the assets will be taxed. This may result in a lower overall transfer tax rate. For future flexibility, clients should consider a power of appointment that will allow the child to treat a transfer to a skip person as a taxable gift rather than a distribution subject to the GSTT. 

* Leveraging. The most effective estate planning is implemented long before death. This is especially true of multigenerational living trusts. A client can apply his or her $5- million GSTT exemption to assets that appreciate by 100% by the time of death, thereby being as valuable as two exemptions. When a client pursues a lifetime generation-skipping gift, he or she should use assets that are most likely to appreciate rapidly. 

* Disclaimer trusts. When a client plans outright gifts to his or her children, the client can establish unfunded multigenerational trusts that will be activated only if the children, seeing an opportunity to take advantage of unused GSTT exemption, disclaim inherited assets or powers of appointment and thereby fund the trusts. 

Let's All Skip 

As long as a client skips one generation, why not skip more for the price of one? Taking Kennedy's estate plan concept to its logical conclusion, a client could create a trust that is a perpetual source of revenue that would avoid transfer taxes forever and would serve as a family bank to finance his or her descendants. 

Although the common law rule against perpetuities imposes a time limit--a life in being plus 21 years can reach about 100 to 120 years--true dynasty trusts can be established, with various limitations, in a growing number of perpetuity havens: Delaware, Idaho, Ohio, New Hampshire, South Dakota, Utah, and Wisconsin now permit perpetual trusts, while Alaska, Colorado, and Wyoming provide for 1,000-year trusts. Nevada and Florida also provide trusts lasting 365 years and 360 years, respectively.4 
Skipping additional generations does not add to the GSTT bill for direct skips--that is, outright transfers--but see Code § 2653 for multiple skips held in trust. 

The GSTT's Third Incarnation

With its fate tied to the Federal estate tax, the GSTT had a $3.5 million exemption and a 45% top rate in 2009. It was then terminated in 2010 but was then reinstated retroactively for 2010 with a zero tax rate and a $5-million exemption. Why an exemption for a zero tax rate? Avoiding a paradox in the event of chronosynclastic infindibular time travel has not yet been confirmed as the intent of Congress, but the truth is out there. 
For the moment, the GSTT will have a 35% top rate and a $5-million exemption for 2011 and 2012 and will likely ride along with the reunited estate and gift tax when it is revised in the next major wave of tax reforms. 

No GSTT Portability: It should be noted that the new estate tax exclusion's portability rule for married couples does not apply to the GSTT. Example: Rocky leaves his $10 million estate to his wife, Ramona, and Rocky's timely estate tax return elects to transfer his unused estate tax exclusion to Ramona. At Ramona's death, she has her full $5 million exclusion available, as well as the $5 million from Rocky. Ramona leaves $10 million to her grandson. Her $10 million exclusion shields her estate from estate tax on that transfer, but only $5 million of the transfer is exempt for generation skipping transfer tax purposes. 

Conclusion 

GSTT isn't quite the nightmare it once was with combined taxes exceeding 100%. But even with $5 million in exclusions and a 35% tax rate, the combined impact is still a force to be reckoned with that will rock an estate backwards. With care and planning, a lawyer can avoid a GSTT asteroid. Keep watching the night skies, and may the force be with you.











]]> How to Review a Commercial Real Estate Appraisal Report: How Can an Attorney Ascertain the Merit of An Appraisal? tag:www.wealthstrategiesjournal.com,2011:/articles//8.6336 2011-11-02T16:59:54Z 2011-11-02T17:28:38Z How to Review a Commercial Real Estate Appraisal Report: How Can an Attorney Ascertain the Merit of An Appraisal?Christopher P. Casey: Before even discussing the appraisal report, perhaps we should address the merit of the appraiser performing the work?... Associate Editor - 3
How to Review a Commercial Real Estate Appraisal Report: How Can an Attorney Ascertain the Merit of An Appraisal?

Casey.jpg
Christopher P. Casey: Before even discussing the appraisal report, perhaps we should address the merit of the appraiser performing the work? What should attorneys look for in determining whether or not the appraiser is qualified for the matter at hand?

John W. VanSanten: At the most basic level, the appraiser should certainly be licensed within the state where the property is located. And this really is a minimum requirement, because while licensing requirements vary among states, they are not overly burdensome to acquire, and many of them allow reciprocity or temporary licenses. In addition, it is preferable to have the MAI designation 
j-vansanten.jpg
from the Appraisal Institute, which is really the preeminent professional association out there for real estates appraisers. An appraiser who holds the MAI designation should possess a high level of experience and qualifications. But in addition, and sometimes more importantly, an appraiser possessing real estate expertise specific to the subject property and market area is key.

CPC: Are there particular property types for which specific experience may be more relevant than for others?

JWV: Experience is certainly relevant for every property type, but it is more important with some special purpose properties. By special purpose properties, I am referring to real estate which has been designed for a unique purpose, such as a stadium or perhaps certain health care facilities. Special purpose properties typically have few, if any, alternative uses due to the high cost in making modifications. Since these properties are less common relative to office buildings or industrial parks, many appraisers simply do not have experience with them.

CPC: As it relates to the appraiser, how can someone reviewing a report investigate the credentials of the appraiser?

JWV: There are a couple of resources which are generally available to the public. First, to verify if a person actually holds the MAI designation, you can use the "Find an Appraiser" function on the Appraisal Institute's website which is www.appraisalinstitute.org. Second, with regard to licensing and state certification, the website for the Appraisal Subcommittee, which is www.asc.gov, can be used to determine if someone is actually licensed, if the license is current, if there have been recent violations, etc.

CPC: Turning our attention from the valuation expert to the valuation report, I understand that there are various types of reports: Self-Contained, Summary, and Restricted Use. Is there any difference among them as far as the scope of the work performed, or is this merely a matter of presentation?

JWV: It is really just a matter of presentation as all three require the same amount of work. But depending on the context for which the appraisal is being utilized, presentation can be important. For example, in litigation, some attorneys may want a Self-Contained report, believing it to be impressive through its exhaustiveness, while others may believe a Summary report is more appropriate to minimize unnecessary questions on matters with little relevance during cross examination.

CPC: Real estate appraisals, unlike business valuations, specifically discuss and ascertain the marketing period and exposure time for the property. Would you please discuss how these concepts influence value? And what should be done in determining these assumptions?

JWV: Exposure time is a retrospective look which answers how long a property had to be exposed to the market prior to selling on the valuation date. Marketing period is a prospective analysis. How long will the property have to be on the market from today in order to sell? If the real estate market is relatively stable, then these two concepts are going to be very similar in duration. However, if the market is appreciating or depreciating significantly, the time periods may be dissimilar. The relevance of these concepts really relates to consistency. If they suggest an appreciating market, has this translated into a higher conclusion of value?

CPC: Regarding the scope of work, can you think of any particular documents or areas of investigation that, if they are not performed, could significantly impact the appraiser's opinion?

JWV: The most obvious red flag would be the failure of the appraiser, or at least someone from his or her team, to have inspected the property. There are instances where the Scope of an Assignment has been limited to the point where a physical inspection is not required. In those cases, the appraiser has to make specific assumptions regarding the condition of the property. However, in matters involving litigation, an actual physical inspection of the property can be very important.

CPC: What other critical subjects within a report should be reviewed?

JWV: The market analysis. Has the appraiser properly identified the correct market for the property? For this situation, think of the very small industrial property which has a local or regional market versus the Willis Tower where the market is national or perhaps even international. Who are the potential buyers/investors? Are they looking for properties locally, regionally, nationally, or internationally? The market analysis will dictate the search for comparable properties and ultimately which are chosen for indications of value.

CPC: As a matter of protocol, would you recommend that sources of market information always be disclosed within the report? For example, if you were utilizing private databases, would you recommend that these databases be cited as well as how the search was conducted?

JWV: Whenever possible, the appraiser should communicate how the information was gathered, and how it was verified. For example, even widely utilized resources, while great for information, possess inaccuracies. And since our conclusions may be highly sensitive to the information reported, it is critical that verification occurs with public records and/or a party to the transaction such as the buyer, the seller, or the broker involved. Not only will this confirm the accuracy of data, but it will also allow the appraiser to understand the motivations at the time of sale and whether or not it is an arm's-length transaction.

CPC: Should the verification itself be cited within the report? Who was consulted, when, and in relation to what particular transactions?

JWV: Whenever possible. I have witnessed too many litigious situations whereby an attorney crosses an expert only to have their verification non-existent or poorly documented. It really diminishes the credibility of the analysis.

CPC: Any valuation is performed as of a point in time, but, especially in today's real estate market, there are rarely transactions that occur as of a particular valuation date, so past information must be reviewed. How far back in the past is appropriate? Is it six months? Two years? What is reasonable?

JWV: It largely depends on the extent of price volatility in the market. In general, you want to stay as current as possible, but in recent years it has been extremely difficult to do so given the dearth of transactions out there. In addition, it varies from situation to situation and depends on the quality of data available. Typically only transactions within the last year or two are utilized, but it depends on the situation and the type of property being valued. To the extent market conditions have changed from the time of the transaction to that of the valuation date, adjustments should be made.

CPC: Moving on to the concept of highest and best use, it strikes me to be of tremendous significance to the appraisal, but I get the impression that it is not fully examined by a lot of appraisers as well as the reviewers of appraisal reports. Would you agree with that, and if so, is it an area which should be critically examined?

JWV: Absolutely. I think a lot of times appraisers tend to gloss over this concept, which can be a significant problem as it is a pivotal analysis underlying the entire appraisal. If the highest and best use analysis is wrong, the valuation conclusion is likely to be wrong. Many appraisers simply assume, "well, it is an industrial property, so the highest best use is as industrial property". That may or may not be true. The analysis of highest and best use should look at the property twofold. First, what would be the highest and best use if the property was vacant and available for development? Second, what is the highest and best use of the property as currently improved? There are four sets of criteria which help ascertain this: legal permissibility, physical possibilities, financial feasibility, and the maximum productive use of the property. Ultimately, the conclusions related to the highest and best use of a property should reflect how the universe of potential buyers would assess the investment opportunity.

CPC: I imagine the test criteria you just described lend themselves well as to questions to ask the appraiser: Did you examine what is legally permissible for the property as if it were vacant? How did you assess the financial feasibility of an improvement to alter its highest and best use? Etcetera.

JWV: Yes, and I should add one caveat regarding legal permissibility. Just because property may be zoned for a particular purpose does not necessarily mean that it is impossible to change that purpose. Agricultural land is frequently rezoned as residential subdivisions in the suburbs. Likewise, industrial land is often rezoned for commercial or residential uses in cities. The appraiser really needs to understand development trends in the area and the propensity of the local municipality to revise zoning designations.

CPC: Are there any market conditions or property types for which a reviewer should pay particularly close attention to the highest and best use analysis?

JWV: Yes, basically any time there is a significant change in market conditions - and by that I mean both positive and negative changes. Changes in market conditions bring changes to the underlying economics of particular properties. With appreciating real estate prices, a marginally profitable machine shop may consider a different location. The inability to find a suitable replacement tenant may cause the owner - and the real estate appraiser - to assess whether or not the property should continue as is or be torn down and built to suit trendy retail shops.

CPC: The asset-based approach in business valuation is infrequently utilized. Is that the same with its equivalent in real estate appraisal, the cost approach? If not, how is it or should it be utilized? Under what scenarios is it most likely to be used?

JWV: Of the three approaches, the cost approach is indeed the least frequently utilized. But there are several situations where the approach may be the most relevant - and possibly the only approach which may be applicable. It is often relevant for new construction. In these situations where you have good data on construction costs, any adjustments for depreciation are likely to be minor. Another example is that of special use properties. These properties, which may have been built for a very specific manufacturing process or other need, do not sell very often, so there is limited data outside of a cost approach. It will always depend on the particular circumstance, but without sufficient market data to apply a Sales Comparison or Income Capitalization Approach, the Cost Approach may be the best indication of value.

CPC: Can you please describe in general terms the steps in performing a cost approach analysis?

JWV: In very general terms, starting with the value of the land as if vacant, the cost to replace or reproduce the facility is added. A good question to ask the appraiser is how they derived these cost estimates. What sources were utilized? To this value may be added, depending on the situation, entrepreneurial profit to induce a market participant to build the facility. But be careful here, entrepreneurial profit must be market supported and there must be evidence that it exists.

CPC: The sales comparison approach to me, and I think any person outside of the real state profession, is simply the most intuitive approach. A building is being valued, there is a similar building in the geographic market which sold for a particular amount, and we can infer a value for the property in question from that sale. Is this approach ever not used? And if so, why?

JWV: The main reason this approach may not be utilized is that there is insufficient applicable data. There may be some markets or some property types - again, special use property types are an example - for which there simply are not any comparable sales. The reliability of the approach depends upon the quality and quantity of available data. This certainly has been more of a problem in recent years. Depending on how limited the quality and quantity of data may be, the approach may either be inapplicable or perhaps, still relevant, but to a lesser extent than normal. In those situations, the other approaches may receive relatively greater weighting in the conclusion of value.

CPC: You mentioned quantity of transactions. How many do you require to draw meaningful pricing information?

JWV: Quantity depends on quality. All things being equal, the greater the quality of the comparables, the fewer number of comparables may be necessary. By quality, one certainly needs to look at the properties themselves: location, physical attributes such as overall property size and age, the legal rights conveyed, etc., but it also has to do with information about the pricing. Has the pricing been appropriately verified? Were the financing terms unusual or typical?

CPC: For how long is an appraisal relevant? This question comes up frequently in the context of estate matters whereby an election to use the value six months after the date of death may be made. It is also relevant in litigation. For example in marital dissolutions where each side may be attempting to stipulate as to a valuation date.

JWV: In today's market, the shelf life of an appraisal may be significantly limited. But it really depends on how the market has performed since the appraisal. And it certainly varies quite a bit by different markets and asset classes. For example, retail has been heavily impacted by the economic downturn, but not necessarily to the same degree in any given market. Properties on the coasts have experienced greater volatility than properties in the Midwest, but not necessarily for any given market or asset class. In general, any reviewer of a report should have a heightened awareness of the possibility that the appraisal is dated - even if we may be talking about a period as short as six months.

CPC: When is the income capitalization approach appropriate?

JWV: For the most part, whenever there is sufficient income data available to result in a reliable indication of value. Oftentimes, it will be the most appropriate and most reliable method of valuing a property. The income capitalization approach consists of two methods: direct capitalization and discounted cash flow. In direct capitalization, a stabilized level of cash flow is capitalized into perpetuity by dividing the estimated net operating income by a capitalization rate to derive value. With the discounted cash flow method, discrete cash flows are projected on an annual basis over a particular holding period, such as five or ten years. The present value of these cash flows are calculated and added to the present value of the property as of the end of the particular period of time utilized.

CPC: Regarding these two different methodologies within the income capitalization approach, when it is appropriate to use one versus the other? And how often, if at all, should a reviewer see both of them at the same time?

JWV: Theoretically, both should produce the same value as they are typically utilizing a lot of the same underlying assumptions. But which one should be employed depends on the expected cash flows. In situations where stable cash flows are expected, for example with long-term leases, there is little reason to use anything other than the direct capitalization approach. This situation is very common with an owner-occupied property. But if there are a number of leases with frequent turnover, or if the property is not fully leased up yet, etc., then cash flows will fluctuate. In these situations, using a discounted cash flow methodology may allow for better flexibility in predicting cash flows and ascertaining the valuation impact.

CPC: Whichever income-based methodology is being used, they follow a basic format: estimate future cash flows and convert those cash flows into a present value equivalent. What are some of the key areas that should be reviewed regardless as to the methodology employed?

JWV: As it relates to "revenue," or rents, the estimate needs to comport with the interest being valued. The rents applicable to a fee simple interest may be very different from the rents applicable to a leased fee interest. The former will be driven by market rents while the latter will solely incorporate current contractual rates. In times of changing market conditions, this may have a profound impact on value even when comparing similar times periods. Vacancy is obviously another key assumption that needs to have sound historical and/or market-based support. As it relates to expenses, a key assumption involves reimbursements for or the pass through of expenses such as maintenance of common areas, taxes, etc. So the terms and conditions of leases, both current and prospective, are a major assumption. Subtracting expenses from revenue generates net operating income to which is applied the capitalization or discount rate, depending on which methodology is employed.

CPC: Where do the capitalization and discount rates come from? That is, how is it determined and how should it be documented within the report?

JWV: Capitalization and discount rates are critical assumptions, and there absolutely needs to be strong support. This is an area where appraisers often fall-short - relying on unsupported assumptions about rates. For support, there are a number of resources available. First, comparable transactions imply overall capitalization rates. It can be calculated by dividing net operating income by the sale price. Second, investor surveys and conversations with participants in the market provide current expectations of investors, so in some respects this may provide more timely data on which to base assumptions. Lastly, rates can be derived from a band of investment analysis. This analysis reviews current financing terms that provide information on various sources of capital. The analysis looks at both the cost of debt and equity, which are then weighted to derive an overall capitalization rate, which implies an overall rate of return on and of the investment in real estate. Using all of these sources and weighing their relative merits at this point in time and for this particular property will allow the appraiser to determine capitalization or discount rates.

CPC: What is the difference between a capitalization rate and a discount rate? Do they derive from different sources? Do they measure the same thing?

JWV: No, they are different, but they share a key attribute. Theoretically, the discount rate is the "return on" an investment required by an investor for a given level of risk. A capitalization rate, however, reflects both the "return on" and "return of" the investment required by the investor. This is another area to review: Has the appraiser been consistent if both a capitalization rate and a discount rate been presented? The investor surveys I previously mentioned tend to be the best sources for discount rates - this is what investors are looking for today as a return on their capital. Sales of comparable properties can be great sources for capitalization rates. So an area to review is whether the assumptions on capitalization and discount rates are appropriately supported.

CPC: In reconciling the different approaches - cost, sales comparison, and income capitalization - I assume in general you prefer to see some consistency between their respective conclusions, but what happens if you do not? How do you derive a conclusion of value given that circumstance? Essentially, how do you reconcile the various methodologies - with or without consistency?

JWV: All things being equal, you would like to see them be within a reasonable range of each other. If they are not, the first course of action is to recheck the underlying assumptions of each approach. But, ultimately, it comes down to deciding which methodology should receive the most weight, which one is the best indication? The answer really comes down to a couple of things. First how are the relative qualities and the quantities of the data available for each method? If you have a lot of great sales, then a sales comparison approach could be a very powerful, reliable approach. Second, one should always keep in mind how an investor will look at the property. If cash flow is the primary driver, then the income capitalization approach may be most reliable. A lot of this goes back to highest and best use.

CPC: Do you have any concluding comments?

JWV: I encourage all attorneys to look beyond the "Pretty Report" and take a closer look at the underlying analysis. Whether you are getting ready to cross-examine a witness or trying to get comfortable with your own expert, taking a critical look at the appraisal can make or break your case.




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