Yeah, I'm the taxman.
Should five per cent appear too small,
Be thankful I don't take it all.
-The Beatles, Taxman, 1966

For most of us, the idea of higher taxes is anathema. In fact, we have been living in a golden age of taxation since President Ronald Reagan lowered taxes nearly a quarter of a century ago.

Well, let's all have a moment of silence for the end of an era. Taxes will rise. You can bet on it.

The first step in that direction comes in the form of sweeping health care legislation: the Patient Protection and Affordable Care Act, along with its amendment, the Health Care and Education Reconciliation Act of 2010, signed into law by President Barack Obama earlier this year.

While a lot of the specifics remain to be determined, it seems to be an opportune time to provide a brief overview of the act's terms and offer some initial thoughts about the impact on investors. We will also review certain other measures being considered that may affect investment and wealth management strategies. Keep in mind that because of the Bush tax reforms, the tax code has become a collection of expiring provisions. So advisors and investors need to stay apprised of the many changes expected over the coming year.

Funding Health Care
To fund health care reform, beginning in 2013, a 3.8% surcharge tax will be assessed on investment income such as interest, dividends, rents and capital gains. This surcharge applies to individuals with adjusted gross incomes above $200,000 and couples above $250,000. The legislation also raises the ordinary Medicare payroll tax by 0.9% for the same filers, bringing it to 3.8%. Interest income from municipal bonds is excluded from the new Medicare tax.

Goodbye, Bush Tax Cuts
President George W. Bush enacted a number of changes to the tax system that resulted in lower taxes across the board-most notably, lower marginal tax rates, lower rates on dividends and capital gains and higher thresholds to assess estate, gift and generation-skipping transfer taxes. However, a sunset provision means that all of these changes will expire at the end of 2010.

The federal government is not required to do anything to increase taxes in 2011 since taxes will automatically return to pre-2001 rates. That means, for example, that the highest marginal tax bracket will return to 39.6% and the long-term capital gains tax will be 20% instead of the current 15%. Qualified dividends, however, may be capped at 20%.

Also in 2001, the estate and GST exemptions were each at $1 million and the top estate, gift and GST tax rate was 55%. There have been proposals in Congress to freeze the estate and GST tax exemptions at the 2009 levels of $3.5 million for each individual or $7 million for married couples, and to keep the maximum estate, gift and GST tax rate at 45%.  There are some other ideas being discussed, such as extending the alternative minimum tax exemptions adopted for 2009 and indexing them to inflation.

Ultimately, the top federal marginal tax rate affecting income and short-term capital gains will climb to 43.4% in 2013 when combining the federal tax rate and the Medicare surcharge. Add in state tax rates and, needless to say, high-income taxpayers are going to experience a big jump in their tax bills.

GRATS
In pursuit of tax revenues, Congress and President Obama have set their sights on Grantor Retained Annuity Trusts or "GRATs." A GRAT is an irrevocable trust designed to allow the donor to transfer assets into the trust and retain the right to receive back an annuity for a term of years, enabling the donor to receive an annual payment for a fixed period equal to the value of the assets contributed plus interest at a rate set by the IRS each month.

At the end of the GRAT term, any remaining value in the trust (i.e., the appreciation and return on the assets exceeding the IRS rate during the GRAT term) will pass to the remainder beneficiaries of the GRAT free of transfer taxes. However, if the donor dies before the end of the GRAT term, some or all of the GRAT assets will be included in the donor's estate for estate tax purposes.

The primary tax benefit-the tax-free transfer of the GRAT remainder interest after the trust term ends-is derived from the fact that the initial gift value of the remainder interest upon the formation of the GRAT was designed to be zero because the total annuity payments to the donor were expected to equal the amount originally contributed, plus interest, thus resulting in no taxable gift. After the financial collapse of 2008, when valuations plummeted across the board, many donors chose to fund GRATs with highly volatile assets which were expected to increase over a short period of time, resulting in the excess principal that could pass to beneficiaries transfer-tax free.

In President Obama's fiscal 2010 and 2011 budget proposals, he has suggested extending the minimum GRAT term to ten years with the expectation of raising $4.45 billion in incremental tax revenues over that time period. Today, most GRATs are structured with no more than two to three year terms to hedge against the possibility of the donor dying during the term. The ten-year restriction is designed to prevent such strategies.

On June 15 and June 17, the House of Representatives passed H.R. 5486, the Small Business Jobs Tax Relief Act, and H.R. 5297, the Small Business Lending Fund Act, respectively.  Both bills are being considered by the Senate as bill H.R. 5297. The new law would: (1) require a ten-year minimum GRAT term, (2) require the remainder interest to have a value "greater than zero," effectively precluding "zeroed-out" GRATs; and (3) prohibit annuity payments from being front-loaded for the first ten-year term. The bill could still be changed before final adoption. If GRAT terms are extended to a ten-year minimum, the donor may need to consider adding an insurance policy to his or her estate plan to hedge the increased mortality risk.

Impact On Investment Portfolios
Advisors need to consider how the changes in the tax code will affect investment portfolios. Potential considerations include the following:

Cash Investments: Tax-exempt money market funds will become increasingly more attractive relative to government and prime money market funds. Risk aside, investors in the highest tax bracket would benefit by investing in tax-exempt money markets on an after-tax basis if the yield were at least 56.6% (1- [tax rate]) of the equivalent taxable money market fund.

Fixed Income: For high-quality fixed income, where little capital appreciation is expected and returns are driven almost exclusively by income, the same rule as for cash investments would apply. For fixed-income investments with expected capital gains, such as high-yield bonds, the tax bite as a percentage will be less, given their capital gains potential, and that may make them suitable for diversification and after-tax return contribution for taxable investors at times when they trade for less than par value.

Multi-Strategy Hedge Funds: Funds employing arbitrage trades where a significant portion of returns are either short-term capital gains or income will be among the most heavily impacted by higher taxes. There are funds in this space that may be more efficient, such as those employing distressed-debt strategies or event-driven strategies, where a more significant portion of returns may be long-term capital gains. Despite the lower tax-efficiency, the diversification value of these strategies may still justify their use.

Equity: Managers with a high level of tax awareness-holding investments until they reach long-term status, holding dividend paying companies long enough to ensure their "qualified" status and regularly harvesting losses (particularly short-term)-will add value to a portfolio. Tax-managed index strategies will become even more attractive on an after-tax basis. This begs the consideration of whether active management should be utilized at all in asset classes where a manager's ability to outperform an index is challenged and the magnitude of outperformance on a pre-tax basis for the most successful of managers is minimal. Exchange-traded funds minimize distributions and are generally considered very tax-efficient.

Directional Hedge Funds: Many long-short equity hedge managers are not cognizant of the tax implications of their strategies. Generally, the managers that run a significant portion of their own taxable assets are more cognizant and tend to run more tax-efficient portfolios. This is an asset class where each manager needs to be evaluated individually as the after-tax performance will vary dramatically.
Private Equity: Private equity has long been one of the more tax-efficient asset classes as income is kept to a minimum and holding periods tend to be long, creating an asset that tends to produce mostly long-term capital gains. Private equity will become more attractive relative to other strategies that have exposure to short-term gains and income generation.

Real Estate: Real estate comes in many different structures-public vs. private, REITs vs. REOCs-and each has its own unique tax treatment. Starting in the public realm, REITs, which must pay out at least 90% of their net income, are taxed at regular income-tax rates since these are not considered qualified dividends. Conversely, REOCs, real estate operating companies, are not required to distribute their income and when they do it would be in tax-efficient qualified dividends. The tax efficiency of private real estate partnerships varies depending on their approach and structure, but they are generally more tax efficient than REITs.

Commodities: Investing in commodities through equities is a relatively efficient way to access the asset class. Investing in a fund that uses commodities futures (treated as 60% long-term and 40% short-term gains for tax purposes) typically is less tax efficient, depending on the underlying collateral held for the futures contract. Most hold either Treasurys or Treasury Inflation Protected Securities (TIPS), which are taxed at standard income tax rates. Some utilize municipal bonds, which are more tax favorable, but the decision hinges on whether the tax-equivalent yield is higher than Treasurys. Finally, the Exchange Traded Note (ETN) can be used where it is considered a prepaid forward contract and therefore is taxed based on maturity or time of sale. ETNs do not typically make distributions generated from underlying Treasury holdings and income generated is not taxed along the way. In fact, if the ETN is held more than a year, the net gain once sold is taxed at the long-term capital gains rate.

In the end, the key question is whether tax changes will affect your strategic asset allocation. While we seek to maximize after-tax returns for our investors, we don't anticipate making major changes to our long-term asset allocation strategies. Tax considerations will manifest themselves mostly through targeted manager selection, as well as sound estate planning and asset allocation. Finally, it is important to note that good investment decisions should always take precedence over tax considerations.

Ronald Albahary, CFA, is chief investment officer of Convergent Wealth Advisors.