THE APERIO DIFFERENCE
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HEDGE FUNDS, TAXES, AND CHARITABLE REMAINDER TRUSTS Charitable Remainder Trusts (CRTs) are a common tool for estate planning. They avoid capital gains taxes when liquidating contributed securities and provide a stream of annual distributions to the donor. However, if the trust assets include domestically registered hedge funds, the income distributions to the donor could be taxed at an excessive short-term gains rate. Including Aperio’s Tax Arbitrage strategy within a CRT can eliminate the short-term gains from other investments, driving significant tax savings.
Patrick Geddes
Copyright © 2011 Aperio Group, LLC
APERIO GROUP, LLC Three Harbor Drive, Suite 315, Sausalito, CA 94965 Phone: 415.339.4300 www.aperiogroup.com
TAX CHALLENGES OF CRTS Overview of CRTs CRTs are now common tools for financial advisors and charitable entities alike. Donors may contribute low or zero-basis securities, which can be sold in the CRT and re-allocated without paying capital gains taxes. The CRT pays annual income distributions (generally to the donors) and the remainder assets pass to the charity upon the donors’ deaths. The benefits to the donors: • Avoid capital gains taxes on selling and diversifying appreciated assets • Provide annual income distributions • Receive a tax deduction for the charitable gift Tax impact of hedge funds in CRTs CRTs themselves are tax-exempt, but the distributions are taxable. The tax rate depends on the types of income recognized within the trust. The IRS taxes every dollar of distribution as Tier 1 until that category is exhausted, and so on down the following four tiers: • Tier 1 – Ordinary Income • Tier 2 – Capital gains (short-term then long-term) • Tier 3 – Tax-exempt income • Tier 4 – Tax-free return of principal The net effect is that distributions receive the highest tax rate incurred in the trust first (“highest rate = first out”). If zero-basis securities are contributed to a CRT and re-invested in funds that create only long-term gains, the distributions would be taxed entirely as long-term gains. However, if the chosen assets in the CRT generate short-term capital gains, the distributions will be taxed at these significantly higher rates first. Hedge funds are a common example of such investments.1 Many investment managers want to increase pre-tax returns and manage risk using hedge funds, but their clients and donors do not appreciate paying taxes at short-term capital gains rates.
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Note that some income from hedge funds other than short-term capital gains, i.e., UBTI, may cause other issues with CRTs. Our focus is on those domestically registered hedge funds and other investments that exclusively generate short-term and long-term capital gains.
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APERIO SOLUTION: TAX ARBITRAGE CRT managers can use index funds to minimize the tax impact on distributions. A better alternative is a version of Aperio’s Active Tax Indexing strategy called “Tax Arbitrage.” This long-only equity strategy can cancel out up to 100% of the short-term gains from hedge funds. The net benefit is to reduce the taxes paid – translated into a percentage, this benefit can amount to 2.0% to 3.2% annually in after-tax performance improvement. A simplified version of Tax Arbitrage works as follows: 1. Start with cash on day 0 and purchase a basket of stocks to track an index (e.g., MSCI EAFE) 2. Sell all stocks that have declined on day 365 creating short-term losses. Replace with similar stocks. 3. Sell all stocks that have risen on day 366 creating long-term gains. Replace with similar stocks Like an ETF, the portfolio in aggregate will track the index’s return. Meanwhile, the short-term losses can be used to offset short-term gains from hedge funds. Importantly, the new longterm gains have no impact on the distribution tax rate. Why? Because a CRT created by contributing and selling a zero-basis security would be taxed entirely at long-term capital gains anyway.
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EXAMPLE ECONOMICS Consider an investor with the following attributes: • CRT with $100MM in assets (originally created with zero-basis stock) • Desired asset allocation includes $70MM of hedge funds and $30MM of long-only equities • 11% annual distribution from the CRT The following chart illustrates the benefit from using Aperio’s Tax Arbitrage strategy versus an equity ETF for the long-only equity assets.
Expressed as “tax alpha”, the $1.0MM in tax savings represents 3.2% in incremental returns on the $30MM in long-only equities. The tax savings also represents an increase of 12% over the $8.3MM in after-tax income available to the investor using ETFs.
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CLIENT CASE STUDY: $300MM ACROSS MULTIPLE CRTS Challenge Advisor’s client had $300MM across four different CRTs. The CRTs were created by the client and a previous advisor with zero-basis stock from an IPO. The new advisor followed an endowment-style investment approach and wished to allocate $100MM to long-only equity, and the remainder to alternative investments, including hedge funds. Aperio solution Aperio worked with the advisor to understand the size of the hedge fund exposure and estimate the anticipated short-term gains. Aperio implemented the Active Tax Indexing strategy with Tax Arbitrage on $100MM of the assets to generate offsetting short-term losses. Impact Resulting tax savings equaled $2MM annually (or 2.05% of the assets managed by Aperio).
The information contained within this presentation was carefully compiled from sources Aperio believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. In particular, none of the examples should be considered advice tailored to the needs of any specific investor. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain.
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