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High-Net-Worth Families & family offices By Timothy M. Tallach & Bruce L. Paulson

Higher Tax Rates and Investing Facts, fiction and action steps

“The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.” —Mark Twain

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igh-net-worth (HNW) families in states such as California, Minnesota and New York can surely relate to what Mark Twain had to say. After considering the 3.8 percent medical surtax and 1.2 percent additional hike for the 2013 reinstatement of the personal exemption phase out and the phase out of itemized deductions,1 highest tax rate taxpayers may see a top federal-state marginal rate of 50 percent or higher. Item by item, the federal tax bracket hikes aren’t pleasant: The tax rate on taxable interest income and short-term capital gains (STCGs) increases 27 percent, from 35 percent to 44.6 percent; the tax rate on qualified dividends and long-term capital gains (LTCGs) increases 58 percent, from 15 percent to 25 percent.2 Unfortunately, the higher tax rate story is still unfolding. President Barack Obama’s 2014 budget proposal contains many provisions designed to make the rich pay their “fair share.”3 What changes should HNW families who want to manage the tax costs of investing be considering today? Here are some thoughts.

Facts “It is better to be roughly right than precisely wrong.” —John Maynard Keynes

Timothy M. Tallach, far left, is head of GenSpring Family Offices’ Wealth Advisory Center in Atlanta. Bruce L. Paulson is a partner at GenSpring Family Offices in Minneapolis

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A few general investing observations are appropriate. First, taxes caused by active manager trading often amount to 1.5 percent to 3 percent per year, possibly higher.4 Second, whether active managers or hedge funds, many perform like the market as a whole—considerably worse after tax costs are considered.5 This isn’t to express a preference for passive investing, but rather to point out that managing tax costs caused by active manager trading is important, especially when considered over longer periods of time. Lastly, several different approaches exist to help manage the tax costs of investing, but for HNW families, managing the task isn’t simple, especially for those that hold their wealth in different trusts, partnerships and across family generations.

Fiction “For every human problem, there is a neat, simple solution and it is always wrong.” —H. L. Mencken Ask five advisors what it means to “manage the tax costs of investing,” and more likely than not, five different plausible answers will emerge. Misunderstandings abound. The most common concerns the concept’s relevance to HNW families, given their total personal financial picture and broader wealth transfer goals. Another is failing to understand where, among different asset classes and investment strategies, managing tax costs is most important and when trying to do so is likely to cause lower pre-tax returns. Consider managed futures, a common “divergent” asset class.6 Realized gains or losses from managed futures funds are typically taxed 60 percent as long-term and 40 percent as short-term,7 a blended rate of 23 percent last year and 32.8 percent in 2013—a 42 percent increase.8 At first glance, the after-tax diversification appeal of managed futures loses its appeal. That first impression, unfortunately, may be wrong. Managed trustsandestates.com

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futures may still serve a useful role, one that, in some portfolios, can’t be accomplished using a more tax efficient asset class or strategy. Lastly, believing in the whole exercise of managing tax costs centers on choosing between active (generally, higher tax costs) and passive (generally, lower tax costs) management. That debate, we assert, is overblown and overly narrow. The reality is that optimizing for taxes, investment volatility and cash needs is dif-

Value-added can come not only from the product, but also from how features of the product save taxes on otherwise taxable gains coming from investments elsewhere in a portfolio.

ficult and requires constant dialogue and coordination around solving for a family’s lifestyle and legacy planning goals and objectives.

Portfolio-Related Actions What portfolio-related actions might HNW families (or fiduciaries) consider to manage the higher tax costs of investing? Here are five points to consider: 1. Understand the big picture, specific to the individual family. Wealth is often held in different trusts, by different generations of the family, each of which are taxed differently. Instruments, such as charitable remainder trusts, (CRTs) lead trusts and intentionally defective grantor trusts (IDGTs), come to mind. Managing them well requires cross-disciplinary expertise and freedom from bank-built, pre-tax fiduciary models. 2. Focus more after-tax energy on the long-term growth portion of the family portfolio. Managing the tax costs of investing here matters far more than doing 28

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the same for assets held for shorter term consumption or lifestyle purposes. To this end, getting the growth bucket “right”—asset mix largely set; investment strategies well selected—is very important.9 3. Make sure active managers or hedge funds are doing something valuable in the portfolio pre-tax. This sounds obvious, but it shouldn’t be taken for granted. If their returns are mimicking or close to market returns, they’re likely falling far short of the same once tax costs are factored in.10 Value-added can be in the form of non-correlated returns, lower volatility and access to unique opportunities. 4. Consider the long-term tax costs of a portfolio built to be more “market neutral” than not. A steady, low volatility ride may feel comfortable (and appropriate), but consider whether, under the new tax laws, it comes at too steep of an after-tax cost. Less tax-generative hedge funds (namely, long-focused or even long/short) might replace more tax-generative (less “directional”) counterparts. 5. Separate account equity index (SAI) portfolios11 gain in after-tax appeal compared to most actively managed equity portfolios. Value-added can come not only from the product, but also from how features of the product (such as systematic security lot-level loss harvesting12) save taxes on otherwise taxable gains coming from investments elsewhere in a portfolio. Consider the following illustration: Under typical market and current tax rate assumptions, the SAI portfolio is projected to generate cumulative income tax savings of 16.7 percent (1.7 percent annually) over 10 years. If the tax losses generated by the SAI can be used to offset higher rate STCGs, these benefits can prove significant. Accordingly, families with significant hedge fund exposures may find the tax loss harvesting benefits of SAI appealing enough to outweigh the pre-tax alphas promised by many active equity managers.

Considerations for Trusts “Simple it’s not, I’m afraid you will find, for a mind maker-upper to make up his mind.” —Dr. Seuss trustsandestates.com

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Tax Ramifications Trust distribution policies can make a difference



Undistributed Personal net investment income (NII) (pre-distribution) Trust NII Modified adjusted gross income Estimated effective federal rate Federal tax on trust income Medicare net investment income tax Total tax payable

If distributed equally to beneficiaries

Trust Level

Single Beneficiary 1

Married Beneficiary 2

$0 $250,000 $250,000 39% $97,500 $9,074 $106,574

$100,000 $125,000 $225,000 25% $31,250 $950 $32,200

$100,000 $125,000 $225,000 20% $25,000 $0 $25,000

Simple compounding at 5% after tax



Annual tax savings $49,376

10 years $652,077

20 years $1,632,609

Assumptions: Calculations based on 2013 published federal income tax tables Beneficiary 1 claims standard deduction and 1 personal exemption Beneficiary 2 claims standard deduction and 2 personal exemptions

— GenSpring Family Offices

While wealthy individuals bore the brunt of many of the tax hikes in 2013, the impact of higher rates and the Medicare surtax become even more pronounced and potentially more punitive for non-grantor trusts. While the highest marginal income tax rates kick in at $400,000 for individuals, the top tax bracket threshold for non-grantor trusts in 2013 is $11,950. Accordingly, now more than ever, it’s incumbent on advisors and trustees to manage this potential tax exposure through a close collaboration around and integration of investment management and trust distribution policies. (See “Tax Ramifications,” this page.) If the trust affords broad discretion in asset management, the trustee will face a number of complex investment choices, including: active versus passive, tax-free versus taxable fixed income, life insurance and annuity products, investment structural considerations—particularly related to alternative asset exposures—including september 2013

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mutual fund, derivative or limited partnerships, timing of tactical gain/loss-harvesting and even the potential for active participation status in business or real estate holdings.13 Fiduciary investment choices will be easier when the trust instrument gives the trustee broad flexibility to: (1) allocate between principal and income, (2) characterize capital gains as fiduciary income, (3) apply broad discretion in making distributions, and (4) take each beneficiary’s unique personal and tax situations into account. However, while the “distributions cure all” approach may make tax-sensitive investing less challenging, it produces greater complexity in administering the trustee’s fiduciary obligations. Just as “the tax tail wags the investment dog,” the same can be said relative to distributions and prudent trust administration. Most trusts aren’t creatures of income tax planning, but rather the result of more comprehensive multi-generational trustsandestates.com

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transfer tax planning, creditor or marital protection and other unique family or beneficiary situations (for example, spendthrifts, special needs and substance abuse). Accordingly, making outsized trust distributions to manage income tax liability will often be short-sighted. Again, only a close collaboration among the fiduciary, investment advisors, planning professionals and even the grantors and beneficiaries can weigh all the necessary and often conflicting considerations and interests to craft a balanced and prudent approach. Beyond the opportunities and challenges presented

Fiduciary investment choices will be easier when the trust instrument gives the trustee broad flexibility. in managing existing non-grantor trusts, the higher rate environment might further increase the income tax planning utilization of split-interest charitable trusts and IDGT planning. CRTs14 may become more popular, but here again, first impressions may be wrong. Of late, the CRT has generally not been an attractive diversification tool; selling and paying a 15 percent LTCG was, in nearly all instances, the more attractive after-tax option. Is the same now true with the LTCG rate being closer to 25 percent, a 66 percent increase? Perhaps. But remember, the CRT isn’t a capital gain elimination strategy, but rather, a capital gain deferral strategy, with taxes paid by the trust beneficiary as annuity or unitrust payments are received over the life of the trust.15 And, how these payments are taxed matters more than many investors realize. If an HNW family defers a tax at 25 percent in Year 1, but receives a series of unitrust payments that are taxed at 50 percent (as ordinary income), the thought emerges: “Might I not be better off just selling the low basis asset and investing the after-tax proceeds in something (index fund or other) that can 30

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be held without a high annual income tax cost, possibly liquidating it at LTCG rates as the need for cash arises, or later (in year 15, for example) if no cash needs exist?” Maybe yes, maybe no. It depends how the CRT portfolio performs and whether it can be managed to minimize the amount of taxable interest, short-term gain and non-qualified dividend income (often referred to as “tier 1” income) occurring inside the trust. And, truth be told, most CRT beneficiaries will want a series of payments that are fairly steady or predictable, thus requiring that taxes be managed while at the same time dampening investment volatility, especially on the downside. The bottom line: a higher LTCG rate does increase the tax deferral advantage of the CRT. The benefit, however, will depend on a number of factors, including how much unrealized gain exists in the original funding asset(s) and, importantly, the after-tax returns coming from the CRT portfolio. Non-grantor charitable lead trusts (CLTs),16 long touted by estate planners for their wealth transfer tax planning utility (particularly in this historically low rate environment), may rise in favor for their lesser understood (but the devil’s in the details17) income tax sheltering attributes. CLTs are taxed as complex trusts under subchapter J, entitled to a charitable contribution deduction (without adjusted gross income limitations) under Internal Revenue Code Section 642(c) for amounts paid to a charitable beneficiary, as long as such payments are made from gross taxable income and pursuant to the terms of the governing instrument. Distributions of net investment income in satisfaction of the annuity or unitrust obligation also escape the lower threshold trust Medicare surtax imposed under IRC Section 1411(a) (2). Accordingly, a tax-savvy trustee is presented with the unique prospect of managing assets for the benefit of both charity and future generation family members in a largely income tax sheltered environment. Until thwarted (or at least questioned) by recent regulations, fiduciaries often relied on cleverly drafted ordering provisions within CLT documents to ensure the most punitive characters of income would be distributed to the charitable lead interest holder and escape taxation.18 For example, consider a CLT invested in three general investment asset classes: taxable bonds, developed equities and non-directional hedge funds. trustsandestates.com

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Assume: (1) the bonds generate taxable interest income; (2) the equities generate lower taxed qualified dividends and LTCGs; and (3) the non-directional hedge funds derive most of their returns from short-term trading taxed as STCG. If respected under state law, practitioners could craft language allocating the most punitively taxed items (interest and STCG) out to the charitable beneficiary as part of the charitable annuity, thus sheltering it with the charitable contribution deduction, while retaining the lower taxed LTCGs to be taxed at the trust level. Under the new regulations, tax-driven management provisions are no longer respected if they lack “substantial economic effect separate from their income tax consequences.”19 The regulations instead require that pro rata allocations of all income character be distributed to the charitable annuitant, thus making custom after-tax portfolio construction more crucial than ever.20 Inadvertent missteps in asset allocation, manager selection, investment structure and even tactical portfolio rebalancing can prove costly to both charity and family, with certain realized income either in excess of the payout obligation or otherwise failing to qualify for the charitable deduction21 potentially subjected to the highest effective federal rate. Once again, close and regular coordination among trustee, investment advisor and tax professional to monitor and manage the timing, character and amount of taxable income/losses generated becomes essential. IDGTs22 continue to offer interesting portfolio management challenges and opportunities, as the grantor can bear the increased income tax burden on trust portfolios for the benefit of future generation(s) without incurring gift tax.23 For several reasons, a conventional pre-tax asset allocation mix for a grantor trust may be insufficient and unwise. First, it may entirely ignore the gift tax benefit of the grantor paying income taxes for his children. Second, because the grantor trust and the grantor are the same end taxpayer, the portfolio decisions inside the trust should be mindful of the grantor’s personal income tax situation, broader portfolio construction, cash flows24 and estate tax exposure. Lastly, more traditional pre-tax asset allocation mixes likely ignore the grantor’s opportunity to integrate income tax basis planning with estate planning through certain retained powers over trust assets25 or the ability to otherwise transact with the trust in an income september 2013

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tax free environment. And, of course, all of these interconnected estate, income and financial planning considerations must be managed while balancing the interests of multiple beneficiaries, or even multiple generations of beneficiaries. A tall order indeed! —The views expressed are those of the GenSpring representatives and are subject to change. They are shared for educational purposes only and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The information is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns.

Endnotes 1. Internal Revenue Code Sections 68(a)-(d) and 151(d) (3) defining the Pease and personal exemption phaseout (PEP) tax provisions. The actual percentage impact on an individual’s effective tax rate is a function of many factors, including adjusted gross income, level and type of itemized deductions, number of personal exemptions and application of the alternative minimum tax. For a more detailed analysis, see Thomas L. Hungerford, Deficit Reduction: The Economic and Tax Revenue Effects of the Personal Exemption Phaseout (PEP) and the Limitation on Itemized Deductions (Pease), CRS Report for Congress R41796, Feb. 1, 2013. 2. Federal rate calculated as sum of 20 percent long-term capital gains (LTCG) + 3.8 percent Medicare surtax + 1.2 percent estimated impact of Pease and PEP. 3. “President’s Fiscal Year 2014 Budget of the U.S. Government” calls for a myriad of tax increases that could impact high income tax payers, including concepts such as limitations of itemized deductions, the so-called “Buffet Tax,” reduction in estate and gift tax exemptions, limitations on accumulations in certain tax-deferred retirement accounts and removal of tax preferences related to certain investments taxed under IRC Section 1256. 4. Since 1992, a host of articles on the importance of managing income tax costs of investing have been published, including: Ludwig Chincarini and Daehwan Kim, “The Advantages of Tax-Managed Investing,” Institutional Investor (Fall 2001); “Tax-Efficient Investing is Easier Said Than Done,” The Journal of Wealth Management (Summer 2001); Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “Loss Harvesting: What’s It Worth to the Taxable Investor?” The Journal of Portfolio Management (Spring 2001); Robert H. Jeffrey and Robert D. Arnott, “Is Your Alpha Big Enough to Cover Its Taxes?” The Journal of Portfolio Management (Spring 1993); Joel M. Dickson and John B. Shoven, “Ranking Mutual Funds on an After-Tax Basis,” NBER Working Paper #4393 (July 1993). 5. Of late, average active manager and average hedge fund performance have proven to look more like the market as a whole than unlike it. If these managers are generating high taxes, the long-term wisdom of owning them is

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dubious. See “Factset, Morgan Stanley Research, Correlation of HFRI Equity Hedge Index With S&P 500 and Annualized Excess Return of HFRI Equity Hedge Index Over S&P 500” charts illustrating growing correlations and diminishing outperformance (alpha) over the S&P 500 from January 1990 to June 2013. 6. “Trend Following: Empirical Findings of Diversification by Less Liquid Markets, International Standard Asset Management (ISAM) Whitepaper,” May 2012; “The Multi-Centennial View of Trend-Following, International Standard Asset Management (ISAM) Whitepaper,” March 2013; Jon Sundt and Allen Cheng, “Convergent and Divergent Strategies: A New Perspective for Evaluating Alternative Investments, Altegris Advisors Whitepaper,” July 2012. 7. IRC Section 1256. 8. Effective federal rate for 2013 calculated as (25 percent LTCG rate x 60 percent) + (44.6 percent ordinary income and short-term capital gains rate x 40 percent) = 32.8 percent (rounded). 9. The primary reason this is true stems from the compounding power of tax deferral over a long period of time. Envision two investments: 1) pay taxes as you go, and 2) pay taxes later. The former creates a low deferred tax liability (an asset on the balance sheet), the latter is designed to build up the deferred tax liability. Now, consider the two net of tax, converting both to cash. Over shorter periods of time (for example, less than seven to 10 years), the cash value of the two portfolios may not be very different; not enough time expires for paying later to work its compounding magic. It’s over longer periods of time that a deferred income tax liability (and compounding on tax savings) works wonders. For this reason, setting assets aside, free from lifestyle driven liquidations trigger income taxes, is more important in the long-term growth bucket of a portfolio than other goal-based buckets that may be spent down, in effect depleting the deferred income tax account. 10. Jeffrey and Arnott, supra note 4. Jeffrey and Arnott explain that the key to successful after-tax compounding is building up a sizeable deferred income tax liability, which means otherwise “spent” tax dollars are working for you, not the Internal Revenue Service. 11. The Economist once quoted John Brennan of Vanguard Group: “. . . If you are going to have an active fund, make it take active bets.” Herein, in our view, lies the problem. Most portfolio managers work in large firms whose policies and incentives dissuade them from building portfolios that stray too far from index benchmarks. Being close to average reduces the risk that clients will take their business elsewhere, even though they’re paying a high fee for returns that mimic the market as a whole. See http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=1685942. 12. Academic studies have examined the benefits of actively “harvesting” losses in a portfolio and show that the cumulative tax benefit continues to rise over time. See Arnott, Berkin and Ye, supra note 4; “Loss Harvesting: What’s It Worth to the Taxable Investor?” The Journal of Portfolio Management (Spring 2001); Paul Bouchey and Hemambara Vadlamudi, “Simulating Loss Harvesting Opportunities Under Different Tax Environments,” Parametric Portfolio Advisors Research Brief (Spring 2012) 13. See generally Tax Advice Memorandum 200733023 (Aug. 17, 2007) and Private

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Letter Ruling 201029014 (April 7, 2010) (trust may materially participate in stated entity’s activities if trustee is involved in operations of entity’s activities on regular continuous and substantial basis). 14. Variation of split-interest charitable trusts qualifying IRC Section 664. From an after-tax investment planning perspective, a thorough understanding of the four tier income characterization and distribution rules under Section 664(b), the 100 percent unrelated business taxable income (UBTI) excise tax provisions under Treasury Regulations Section 1.644-1(c) and the private foundation excise tax provisions under IRC Sections 4941-4945 is essential. 15. Treas. Regs. Section 1.644-1(d). 16. Based on the provisions of IRC Sections 170(f)(2)(B), 2055(e)(2)(B) and 2522(c)(2)(B), a charitable lead trust (CLT) is a split-interest charitable trust that pays a regular recurring annuity or unitrust amount to charity for its stated term, at the end of which it distributes its remaining assets (if any) to or for the benefit of non-charitable beneficiaries. The non-grantor CLT is taxed like any other taxable trust. Undistributed income is taxed at trust income tax rates, which reach the maximum marginal rate at relatively low levels (as discussed above). See generally Karen E. Yates and Stephen Liss, “Charitable Lead Annuity Trusts-A Primer,” 19 Tax’n of Exempts 23 (July/Aug. 2007). 17. See Elyse G. Kirschner, “Income Ordering Rules for Trust Distributions to Charity,” Trusts & Estates (May 2013) at p. 22 for an overview of the income ordering rules and outstanding uncertainties related to CLTs under the 2012 IRC Section 642(c) final Treasury regulations. 18. Treas. Regs. Section 1.642(c)-3(b), Ex. 2. 19. Ibid. 20. Distributions of income to the charitable lead beneficiary must include a prorata share of the various types of income earned within the CLT under Treas. Regs. Section 1.642(c)-2(b)(2)). 21. Income attributable to both tax-exempt income (as it’s not a component of the trusts gross taxable income) and UBTI—often related to leveraged investments—can result in the disallowance of the trust IRC Section 642(c) charitable deduction for the amounts attributable to these income types. 22. A trust, the transfers to which are completed gifts for gift and estate tax purposes, but which is still treated as if it were owned by the grantor for income tax purposes (due to some retained power or control under IRC Sections 673-678), is sometimes called an “intentionally defective grantor trust” or IDGT because the grantor intentionally violates one or more of the grantor trust rules. 23. Note that President Barack Obama’s 2014 Proposed Budget includes provisions that could potentially impact the planning utility and flexibility offered by IDGTs. 24. Jerome M. Hesch, “Financial Danger if Maximizing Taxable Gifts in 2012,” LISI Estate Planning Newsletter #2035 (Dec. 5, 2012), www.leimbergservices.com; Compare Alan Gassman and Christopher Denicolo, “Defective Grantor Trusts Are Not Black Holes,” LISI Estate Planning Newsletter #2068 (Feb. 21, 2013), www.leimbergservices.com. 25. Usually through the nonfiduciary power to substitute assets under IRC Section 675(4)(C).

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