The political pundits are busy making predictions about the November election, and the outcome is far from certain. Still, the smart money is already starting to consider the financial impact of the election, no matter who takes the White House. With current low tax rates on capital gains and dividends likely targets in any tax debate, it may be a good time for advisors and their clients to consider taking action-shedding capital gains in their portfolios, increasing current dividend distributions from private companies and perhaps even selling their businesses.
Political winds may also affect interest rates, which are also at low ebb. The likelihood of higher rates in the future, politically induced or otherwise, accentuates the desirability of seizing the day to now implement certain gift and estate tax strategies that gain added horsepower in a low-interest-rate environment.
Political Meta-Planning
The idea of "meta-planning" of this kind is to take planning to the next level, not only taking into account the selections available from the current menu, but considering how the menu might likely be changing. Such planning is common practice among the super rich, often spurred on by their teams of advisors, who have seen their clients' fortunes affected by everything from energy policy to tax law changes. Clients of more modest means can play the same game. They should also be thinking about the potential financial ramifications of the upcoming election. Indeed, anyone who owns stocks, mutual funds, a business or a home will likely be affected by tax law changes that many expect to win passage next year or else in 2011, when the Bush tax cuts of 2001 and 2003 expire.
The new president will not take office until January 20, 2009, but that does not mean taxpayers can dawdle. Tax legislation passed midyear commonly contains provisions that make it retroactive to a prior legislative date (such as the date the bill passed out of a tax committee) and often to the beginning of the calendar year. That means those who want to position themselves for the coming administration should act fast. They might have only until December 31 to take action, and some strategies can take months to implement.
Gaming-Low-Rate Taxes Hold 'Em
Tax policy will most certainly play an important part in the next president's efforts to jump-start the economy, no matter which candidate is elected. Republican John McCain is currently talking about tax cuts, while Democrat Barack Obama has proposed key tax increases to help balance the budget. While the presidential candidates are getting most of the attention, it is Congress that controls the purse strings. That means the makeup of the new Congress will be a critical factor, determining whether the next president will be able to pass his tax legislation.
Sunset provisions built into current tax law, however, make it certain that both the capital gains tax and the tax on dividends will be on the legislative agenda. Both these rates are currently at historic lows, thanks to provisions in the Jobs and Growth Tax Relief Reconciliation Act of 2003. But these rates are set to expire at the end of 2010 unless Congress takes action.
The current capital gains rate now tops out at 15% and has disappeared entirely for anyone in the 10% and 15% income tax brackets. If the law is not extended, capital gains taxes will return to pre-2003 rates, which in most cases were 20% (18% for qualified five-year property). That means Uncle Sam will get a much bigger bite out of the profits in any sale of stocks, bonds, homes or businesses. Inquiring minds are bound to ask: Will a new Congress leave us to enjoy the sunshine of low capital gain rates as scheduled for another couple of years, or will it extend the sunset further-or maybe accelerate it?
Given the political winds, people who have large gains in their portfolios should at least consider selling stocks and bonds to take advantage of today's low rates. The same holds for business owners who have been thinking of selling. Ditto for home owners with gains that exceed the current $500,000 exemption allowed for couples filing jointly or exceed the $250,000 for single filers. The battering of stock prices might dovetail here with tax rate planning, since both the amount of accrued gain and the tax rate might be aligned at modern lows. The cost of exiting an investment now may be lower than what the investor will see again for a while.
Taxes, of course, are only one consideration. People should balance any tax advantages with long-term goals, financial needs and current market conditions. Given a battered stock market, some people may find that selling has the advantage of helping them shift to more conservative investments. Others, such as business owners who have been considering a sale, might find that there simply are not any buyers. Or they may decide to continue running their business in order to build a more secure retirement.
Dividends-Going For All The Gusto
With a current maximum rate of 15%, taxes on dividends are now at their lowest rate since World War II. In the past, dividends have been taxed as ordinary income, and that is how they will be taxed again if the current law is allowed to sunset at the end of 2010. But again, what will a new Congress do with these rates? Given the present uncertainties, business owners with C corporations may want to consider a substantial current dividend distribution to shareholders, treating the current year as a historic opportunity to clear out earnings and profits at rates perhaps unlikely to appear again. Clearing out all accumulated earnings and profits may be particularly attractive to an owner of a C corporation whose income consists significantly of passive investment income, perhaps as a result of a prior sale of an operating business. After the owner has cleared out the accumulated earnings and profits, he may convert an otherwise-eligible C corporation to an S corporation. The tax code, in effect, prohibits such a conversion if there are accumulated earnings and profits, imposing a penalty tax on passive investment income, followed in three years (if uncorrected) by a mandatory termination of the S election.
A Plug For Estate Taxes
Another area likely to attract Congressional attention is the estate tax. The exemption from this tax has been gradually rising, reducing the number of people whose estates end up with tax liabilities. This year, estates of less than $2 million are exempt from the tax, and that limit will rise to $3.5 million in 2009 before the tax disappears entirely in 2010. Once again, however, sunset provisions included in the original legislation mean that the law will expire at the end of 2010. The estate tax exemption will then revert to the $1 million amount provided under the old law.
As a result, the size of your estate tax bill can depend on the year that you die. While an estate planner with a macabre sense of humor might predict a mysterious power surge turning off all the life support machinery at the stroke of midnight on December 31, 2009, there is otherwise not a lot of planning that can be done around the timing of the estate tax. All of these changes and uncertainties, though, highlight the importance of continuing to monitor one's estate planning and building as much flexibility as possible into it. A good estate plan should have the flexibility to adjust to these annual changes, as well as possible revisions in the law that are likely to take place before the current law expires.
Turbocharging An Estate Plan
The outlook for interest rates under the next administration is another important planning consideration. Interest rates are still near their historical lows. This clearly affects investment decisions, but also benefits several wealth transfer strategies that allow people to pass on a greater share of their wealth to their heirs. Individuals who might bet on an increase in interest rates might want to seize the opportunity to implement one of these strategies, especially those entailing an estate freeze of some kind, while it is still possible to turbocharge the planning with low rates.
On the simplest level, a wealthy individual wanting to benefit family members at the least cost to them can loan them money at a relatively attractive rate. Old loans might be renegotiated at a new, lower rate. In a similar vein, a wealthy donor might sell property in an installment sale for a low-rate note. Such a sale may be structured as a taxable sale or, in a more sophisticated arrangement, as a nontaxable sale to an intentional grantor trust. If the asset sold produces a yield in excess of the interest being paid, then such excess should benefit the buyer, without being treated as a taxable gift.
A grantor retained annuity trust, or GRAT, is another estate-freezing device that can become more advantageous in a lower interest rate environment. An individual places into a GRAT assets that are likely to appreciate and that he wants to give to his heirs. In exchange, the grantor receives annuity payments. When those payments are higher, what remains in the trust will be lower and so will the value of the gift for tax purposes. In fact, a GRAT is commonly structured with a predetermined annuity payment sufficiently generous to result in a zero value being placed on the gift. The lower the interest rate, the lower the annuity payments needed to "zero out" the gift. When the assets have appreciated to an amount that is greater than the cumulative annuity payments, it leaves a tax-free surplus return for the remainder beneficiaries. The current low interest rate environment, therefore, increases the likelihood that the assets will appreciate sufficiently to make the strategy work.
Similarly, a charitable lead annuity trust also benefits from low interest rates. In establishing a CLT, a person makes a gift to charity of annuity payments for a fixed term (measured by years or the lifetime of one or more persons). At the end of the annuity term, the trust assets pass to beneficiaries such as children or grandchildren. Once again, the lower the applicable interest rate, the greater the charitable deduction and the lower the gift tax on the assets that ultimately pass on to the non-charitable beneficiaries.
Still, the most important part of election-year planning is the fact that it gets people thinking. Washington politics clearly have a significant impact on the financial fortunes of both the wealthy and those of more modest means. By taking into account such events as presidential elections in their long-range planning, people will be able to take advantage of opportunities and avoid many risks.
Kenneth P. Brier is a partner of Brier & Geurden LLP, Needham, Mass., a boutique law firm focusing in the areas of taxation, estate planning, business planning, trusts and estates, and executive benefits.