Restricted management accounts can improve returns.

If you are tired of clients starting to zero in on short-term performance after a strong market in 2003, take a look at the estate planning world. Perhaps you should be considering restricted management accounts (RMAs) for clients with estate tax concerns and oversized individual retirement accounts.

In brief, an RMA is an account governed by a contract between an investor and a bank or trust company. Under the contract, the investor cannot access funds placed in the account for a stated period-five years with a one-year rolling renewal is common in practice. Registered investment advisors may not enter into these agreements because under Securities and Exchange Commission rules, clients can not be denied access to their funds.

The investor retains ownership of the restricted account, which perhaps may be transferred. However, control over asset management is turned over to the institution or an independent, trust-protector-like third party, which may then tap you to serve as investment manager. The lock-up lets you stay fully invested as you invest for the long run, rather than quarterly performance, to provide the client with potentially superior returns.

In addition, proponents aver that the illiquidity, limitations on transfers, lack of control over the investments and other factors may merit a 20% to 40% discount from the account's market value for federal transfer tax purposes-notwithstanding the fact that RMAs are so new that they're neither court-tested nor sanctioned by the Internal Revenue Service. The advanced technique can be useful in late-life planning scenarios, with sales to defective trusts, and when IRA assets aren't needed for living expenses, says Jeffrey Lauterbach, chairman and CEO of The Capital Trust Company of Delaware, in Wilmington.

A financial advisor is "the ideal person to be recommending an RMA because then the client selects it as one of many investment choices put forth," says David A. Handler, a partner at law firm Kirkland & Ellis LLP, in Chicago. In many cases where the IRS has successfully attacked discounts begat by family limited partnerships, the taxpayers had learned about family entities from their estate-planning attorney-a genesis courts consider dubious for something supposedly motivated by business, rather than tax, reasons. "The RMA should be suggested as an investment product whose primary purpose is to manage money for long-term return and which may have potential estate tax benefits," Handler says.

But the new tool may not enthuse every advisor. The agreement moves the decision about who manages the client's money away from the client, and while it is possible for you to be named investment advisor, there is no guarantee. Even if you are appointed, you can probably be dumped at will. Despite such shortcomings, the RMA can provide an advisor with entrée to the next generation of clients. At death, the agreement continues for its remaining term and is counted as an asset of the estate. "If someone inherits an RMA with four years left, they'll get to know the money manager over the next four years," Handler says.

Select Clientele

Among the best candidates for a restricted management account are sophisticated clients interested in pursuing valuation discounts without the fuss and uncertainty of a family limited partnership (See sidebar). "The transfer restrictions in an RMA account can be structured similar to those of an FLP," says Domingo P. Such III, a Chicago partner in the law firm McDermott, Will & Emery. "With both (non-IRA) RMAs and FLPs the planning question, depending on the client's objectives, is whether the client should gift ownership units or hold them," Such says.

Loss of control over the investments for the contract term makes the upstart technique appropriate only for those who can let go, observes Barry Kohler, a certified financial planner licensee at BDMP Wealth Management in Portland, Maine, an affiliate of accounting firm Berry, Dunn, McNeil and Parker. The affluent generally detest relinquishing power, as advisors know. "It gets magnified with an RMA because you're talking about investable assets, something the client is used to managing," Kohler says.

The client must also have a sizeable estate-mid-seven figures or higher. RMA minimums are usually measured in millions, and the inaccessibility to funds means a client cannot afford to put in his entire wealth or assets needed for paying death taxes. "We worked with an estate that was about $15 million, and the client put $2 million in the RMA," Kohler says.

Of course, because the technique has yet to be addressed by the IRS, it is only appropriate for clients who can tolerate working in the gray zone, Kohler says. "We talk to clients about litigation risk" before recommending an RMA, he says.

Costs include legal fees to draft the contract, custodian fees and an appraisal to substantiate the valuation adjustment. At least one bank is reportedly studying whether it is feasible to charge a reduced asset management fee on RMAs, since the account can't leave for the contract term.

Potential Transfer And Income Tax Benefits

RMA discounts vary from case to case depending upon the particulars of the contract and the assets held at appraisal. Agreements covering longer periods deserve heftier discounts, for instance, and perhaps so do accounts that own illiquids or products with rapacious exit fees. A key factor is whether RMA income (which is taxable currently to the client) is retained within the account or is distributed to the extent of the income tax bill it generates. "The discount will be greater if there are no distributions for taxes," Handler says. Here's how the discount plays out:

At death, Lauterbach explains, if the RMA owns assets valued at $5 million and it is entitled to a 25% discount, the account's value for federal estate tax purposes is $3.75 million. In this case, the valuation adjustment saves as much as $600,000 in death tax. Although the RMA can't be touched to pay any tax due, its discount reduces the client's liquidity needs at death, potentially impacting other parts of the financial plan, says Lauterbach.

In the IRA context, the RMA discount may save the client income taxes during her life, according to Such. A discounted account value produces lower minimum required distributions (since they are a function of the account value). That suppresses the client's income, lowering taxes, Such says.

Practical Considerations

For the independent advisor, the first step is to locate a willing and capable trust company. Although an RMA is a contract, its legal implications are wide-ranging. "Securities laws, banking law issues, income, gift and estate tax issues-all of those come into play," says Handler, who has helped develop agreements for Wachovia Bank and Citigroup. The advisor's due diligence on institutions offering the accounts includes asking whether experts from the various disciplines were involved in the drafting of the contract.

Advisors should also ensure that the institution intends to honor its agreement to not disburse funds from any of its restricted accounts, regardless of how badly an important customer needs cash. "If a bank or trust company gives a client his money back before the contract ends, that jeopardizes the validity of the (institution's) contract for all of its clients, not just that one," Handler says.

The RMA account should be registered to a single owner in order to obviate certain valuation rules applicable to partnerships under Internal Revenue Code Chapter 14, a favorite IRS attack route. Advisors to married clients in community property states should seek local counsel regarding the implications for RMA account ownership.

Beyond that, all you have to do is manage for the long term.

Newcomer And The Aging Champ: RMA Vs. FLP

Restricted management accounts have quietly been gaining currency in direct proportion to watershed victories by the IRS in its war against the once-invincible family limited partnership. Strangi II, Kimbell and other recent cases show that FLP clients really can't retain control if they are to reap a valuation discount, nor can they ignore the entity's formalities.

The latter is not an issue with an RMA. It's a contract-there are no meetings to hold and document, or annual tax filings. So it's simpler and less costly to create and administer.

The RMA also offers potentially more secure discounts. As an investment vehicle designed to enhance long-term returns, it has the one thing that the IRS likes to assert many FLPs lack: a bona fide business purpose. Moreover, an RMA is an arm's-length agreement between unrelated parties, unlike most FLPs.

Another advantage of the RMA is its low profile. When a client with partnership interests passes, a box on the federal estate tax return (Form 706, Part 4, Line 10) must be checked yes. That flags the return for audit. But with an RMA, Line 10 is answered no.

Not everyone hails the newbie, however. It has sparked sometimes heated discussions in the law journal Trusts & Estates and among the heady membership of ACTEC, the American College of Trust and Estate Counsel. FLPs clearly still have fans, including T. Randall Grove, who spoke about using them in the current environment at January's Heckerling Institute on Estate Planning.

"My reaction (to IRS victories in FLP cases) is that there has to be a significant and relevant change in the client's circumstances before and after establishing the family entity," says Grove, a shareholder in the law firm Landerholm, Memovich, Lansverk & Whitesides, in Vancouver, Wash. "The state of the (FLP) law is that we have to stay away from plans and transfers that only take on real significance after or upon a person's death."