Many investment advisors struggle mightily for investment returns, only to have 50% disappear annually or at the client's death. Where does the money go? Into the hands of the Sheriff of Nottingham, popularly known as the Internal Revenue Service, with a knowing, aggressive and revenue-hungry Congress behind.
There is no question that federal and state income tax laws as they apply to your clients are confiscatory, if not vicious. On top of these annual tributes to Caesar, the gift, estate and generation-skipping taxes are very much alive and well. The federal estate and generation-skipping taxes, at the writing of this article, are to disappear in 2010, but for one year only. The rate on transfers from one person to another may work itself all the way down to 45% in 2009 from 50% in 2002-hardly meaningful relief.
Exemptions from the federal estate tax increase to $1 million this year and are scheduled to go to $3.5 million per person in 2009. This helps, but it is not sufficiently good news for many clients. In bad states, most of them have faced a combined federal and estate income tax rate of 45% on ordinary income and a 25%-plus tax on capital gains. But they also will lose 50% of their wealth at death or pay a hefty tax on property transferred during life. By the way, the federal gift-tax exemption stops at $1 million this year until 2009 and beyond; the exemption on gifts does not go up to $3.5 million in 2009, as it does for the estate tax.
A person annually may give $11,000 per recipient, and those transfers are excluded from the gift tax. Also excluded are payments a person makes directly to the provider of medical services or tuition for anyone. The rendering of services is not a gift, nor are court-ordered involuntary transfers, such as in bankruptcy and tort claims or business transfers. Divorce-related payments generally are excepted if strict requirements are met. Everything else is fair game.
All of this is depressing, but we have weapons to preserve and protect the wealthy from Enemy No. 1. The phrase, "The power to tax is the power to destroy," was correctly conceived and properly stated. Did we not begin as a country, in part, over a tax battle? It had something to do with a levy on tea, did it not? Another wag put this controversy into context with the statement, "Death and taxes are both certain; but only taxes occur annually." With the death tax so severe, it really only needs to occur once. Its nasty tentacles wrap themselves around the wealthy at death like a federal octopus bearing the United States flag on its back. States have death taxes, too, and that scene is getting worse as well.
Another problem ahead will occur in 2010, the year the death tax is repealed. Even if Congress makes good on its often-enunciated desire to "make the 2010 repeal permanent," it has arranged for something just as ugly to take its place, which is called "carry-over basis."
Undoubtedly you are aware that until 2010, when a person dies the basis of all assets in the estate (even those passing tax free to the spouse) are adjusted upward or downward, as the case may be, to the federal estate tax value. That amount is the fair-market value of the assets on the date of death or on the date occurring six months after death. However, the latter applies only if the total value of the assets on the day a person dies and the estate tax both go down as of the date six months later.
Let me throw to the taxpaying dogs several delicious bones. I mean no disrespect by any of these comments and struggle personally with these taxes, as do most of our clients. But there are rays of hope for those who plan and have insightful and creative tax counsel. I will conclude with two tantalizing ideas for tax planning, both sound and creative. There are many more!
My partner Marc D. Teitelbaum, who is the nationwide head of our Pure Tax practice in New York, has quite a distinguished group practicing with him. He is no stranger to good ideas. In a recent conversation, he informed me that the current plight of many investors is that the drop in the investment markets has produced for them potential long-term capital losses that would be recognized upon the sale of such investments. His group has developed a technique to turn these long-term capital losses into ordinary losses, which benefit investors by substantially reducing ordinary income.
So much for an idea whose timing is perfect on the income tax side. What about the transfer tax side? The estate, gift and generation-skipping taxes, we've often stated, take their "pound of flesh." But with investment returns in many cases lower than they have been over the past 10 to 15 years or so, the old estate-planning dog is learning new tricks.
Suppose you had a trust for your client's descendants that wasn't subject to estate, gift or generation-skipping taxes. And suppose you could sell to that trust your client's securities that had declined, but not to a level below his or her basis.
In other words, your customer paid, let us say, $1 million (the basis). The securities in better markets rose to $10 million, but have declined now to $5 million. You believe the securities are high quality and would eventually return to $10 million in value, or more.
Your client sells the $5 million in securities to the trustee he or she selects (the trustee cannot be the client). The trust is irrevocable and for the customer's descendants. If your client wants, the trust never has to end. The trustee gives the customer, in exchange for the $5 million sale, a note for $5 million at a federally mandated rate, which now is about 5%. The interest can accrue, but if paid to your client, it is not income. Furthermore, the $5 million sale to the trustee is not recognized as a capital gain in this type of trust.
Five years from now, when the stocks indeed return to their $10 million value, the trustee sells them (you are the investment advisor to the trustee); the note is paid off to your client and there is a handsome $5 million in the trust for descendants ad infinitum. The trust may specify that the fund may be used under certain terms or conditions-paying for college, buying a new house, getting married, starting a business-whatever. Your client must pay taxes on the $9 million gain ($10 million minus the $1 million basis) when the trust sells the securities, but the customer can do that comfortably out of the $5 million note proceeds.
Your client isn't taxed on the note's proceeds, and if your customer preferred stock-in-kind in exchange for the note, that is not a taxable event, either. This technique is called an "Intentionally Defective Grantor Trust."
Our quivers are full of arrows. You have only heard of two of them in this column. Yes, competent guidance is necessary to implement these techniques and risk must be assessed, but I would not be writing about the concepts in this column if the law were not supportive. Gold can be mined in difficult times or prosperous times, and intellectual property is no different. Keep what is yours and what belongs to your customer as well, undiminished by taxes or at least by much lesser taxes. It is your Constitutional right, as U.S. Court of Appeals Judge Learned Hand wrote in an important decision, to take every step necessary within the law to protect your clients' assets from taxation. The Internal Revenue Code is fertile ground, ironically, for ideas to avoid the very taxes it imposes.
Roy M. Adams is a partner in the law firm Sonnenschein Nath & Rosenthal, based in New York City.