By Carl L. Sheeler, PhD, ASA
About six years ago, I was on a family office panel put on by Opal Financial in Newport, RI. About $2 Trillion in wealth is represented at such events. The gist of my presentation was March 2009 marked the lowest decline in public stock market values since the Great Depression. It was a key tipping point – perhaps more extreme given tepid growth in its aftermath. Much of the attendees wealth was derived from investment in distressed assets (real estate, company debt and equity) acquired at steep discounts.
These families had the liquidity, patient capital and iron constitutions to wait out the rebound, which came in the form of federal dollars flooding the market, when corporations and banks could or would not take the risk. The subsequent benefit of those with work income (most earnings from efforts) were those who remained or returned to the stock market. Even more so were those with wealth income (earnings from investments) often derived from concentrated risk (owning a business or real estate).
Not so for those in default and those who lost or couldn’t find well-paying jobs. Many are the disenfranchised supporting Donald Trump or supported Bernie Sanders. They’re along the Economic Darwinism bell-curve. They are the Boomers who have insufficient savings to retire so slow the upper-mobility of Millennials who boomeranged back to their parents’ homes and can’t repay their collective $1 trillion in student loans. Then there’s the fixed-income seniors whose accounts’ yields are paying one-twentieth the inflation rate.
There is an aptitude and attitude issue here. First, the wealthy and the corporations had access to significant debt to leverage their investments as long as growth was fueled by even more credit. Much of consumer debt was via easy-approval home loans and lines of credit from their homes’ equity.
Risk shifting went to the banks carrying this debt on their books. From a simple financial model, debt is cheaper than equity, so the pre-2008/9 price of stocks were inflated by the leverage. Consumers enjoyed their temporary lifestyles from their work income and access to their equity as if the two were indistinguishable. It was a wild party until the music stopped. The economy was humming because all the income and gains were taxable, but much of the growth was fueled by consumption using debt.
Sadly and unwisely, the public’s emotional benchmark were these “good times” derived from leverage, not because they had more discretionary income. Yet, it’s unrealistic to expect that feeling of “success” ought to return without a personal change in circumstances. But often feelings sometimes gets confused by fact. The same might be said by the current stock market highs.
So, the “recovery” fueled by “cheap” currency has created two anomalies. First, if one can borrow at an interest rate half of 7.5% (was the norm for many years for home loans pre-2008), then the 3.75% rate buys twice the home. The same holds true for the “cost of capital” to corporations that de-levered (first reduced their debt), then re-levered (refinanced) at lower interest rates, which served to elevate the value of their shares. Second, the real question ought to be: (a) Is using the period of 2007 as a benchmark for a return to stock market performance realistic?; and (b) Are the current index values properly reflecting consumer demand and company operational fundamentals or is it irrationality more emblematic of the last bubble created by debt and less so by demand?
Clearly, the US Treasury and IRS benefitted from the supersized capital gains and income taxes leading up to 2008 (feeding the beast). But what of the periods following and what recourse could these agencies take?
The U.S. public is the largest block of consumers and are the engine of the U.S. economy went into saving mode when the market declined; especially, as many were one lost paycheck short of being impoverished. Their influence reemerged for the auto industry as they bought cars at record numbers the last six years. But the canary in the coal-mine, these working and middle class folks, are back to credit card purchases at higher interest rates as work income is insufficient for their buying behaviors.
The socio-economic implications are huge. In short, where would the stop-gap be for these tens of millions of Boomers when their meager savings runs out as it surely will? More tax revenues as a safety-net seems to be the natural response. From whom, if large corporations are permitted to have teams of attorneys and accountants capable of reporting profits for Wall Street investors, but losses for the taxman or simply off-shore tax avoidance havens that keep hundreds of billions of US corporate profits from being repatriated. These would be tax revenues that provides our homeland security practices and military to protect their global interests: infra-structure for their headquarters: and defend fair-trade
Two things were learned from the great recession. The ultra-wealthy ($30 million-plus net worth) questioned the alignment of their families liquidity, leverage and legacy goals and that of banking, tax, legal, insurance and wealth management institutions’ motivations. Their mistrust is rampant due to the loss of accumulated family wealth in 85% of the cases by the third generation. This is under the “watch” of the teams of the aforementioned trusted advisors. This may explain focus on fees; why 80%-plus of widows fire their husbands’ advisors; and over two-thirds of heirs fire their benefactors’ advisors.
Further, many decided this was the time to ensure allegiance was to the family by establishing family offices where they could ensure having 24/7 focus on their wealth. Many eschewed private equity and hedge funds and increased their direct investment preferring more transparency, control and higher returns to less liquidity and marginal performance (often below passive index funds). Some families transitioned to offering private debt funding through more direct engagement with commercial borrowers. The impact of Dodd-Frank and Basel III on commercial lenders contributed to this demand.
The other factor was the somewhat unusual increase in the lifetime exclusion (with portability) of the estate tax increasing the amount to $10.9 million this year (would have lapsed to $1 million) with a gift tax exemption of $3.5 million. Otherwise, depending upon the reader’s political stripe they might be looking at a 45% estate tax rate for wealth above $3.5 million and above $1 million in gifts.
History is about to repeat itself. In December 2013, I published a peer-reviewed thought-piece in Thomson Reuter’s Valuation Strategies: Valuation at the Crossroads cautioning the potential “blowback” of poorly supported valuation and discount business appraisal reports. Almost three-decades ago, Family Limited Partnerships were the clever devices for affluent families to compress the value of their accumulated wealth by transferring equity from one generation to the next. As the equity was usually restricted and had a limited market, the pro rata value would be lowered by these impairments as notional investors would seek a concession referred to as “discounts”. The level of these discounts could be considerable. So, if 1% was a controlling interest and 99% was non-controlling and the value of the underlying asset/entity was $20 million. Then the 1% held in the FLP would be worth $200,000 and the 99% worth $19,800,000 on a pro rata basis.
However, applying the discount, say 40%, would leave a value of $11,880,000 for the 99% or $12,080,000 combined for the 100% equity. If the tax rate was 40%, the tax savings was $3,168,000 with $7,820,000 in value “disappeared”.
The support for these discounts were often questionable due to limited oversight of the business appraisals performed as compared to the real estate appraisers who were forced to become state licensed as a result of the late 1980’s Savings & Loan crisis. The Treasury Department and IRS fought these discounts and by obtaining administrative approval changed the tax code by instituting Internal Revenue Code Chapter 14: Sections 2701 – 2704.
When the ink was dried, the loop hole was effectively closed until more sophisticated estate planning prevailed. About a decade ago, House Resolution 436 was considered in committee. It would try to close these newest “discount” loopholes, but it would have been politically unpopular at the time. In last week’s Wall Street Journal (August 3, 2016: US Targets Tactic To Avoid Estate Taxes) article, the US Treasury and IRS are again seeking to eliminate these discounts.
They would be doing this by amending Section 2704 with proposed regulations that include significant restriction and/or elimination of these discounts. While that might be inconsistent with constitutional rights, market and economic realities, it would be a heck of a way to capture hundreds of billions of new tax revenues through a social construct to lower all wealth by redistributing income versus creating more wealth (and associated taxes) by raising investment. Worse, is if these become final regulations, it likely would occur by or before January 1, 2017 leaving little time for UHNW families to plan.
So, who stands to lose by closing this loophole? The founders and their families who have taken concentrated risks and amassed wealth whether it’s 8-, 9- or 10-figures. These are the same families that created tens of millions of jobs that stimulate the economy and generate tax revenue. These 8-figure and greater annual sales companies never received a separate consideration as private corporations and are expected to pay the same level of “C” corporate taxes unless making an “S” election. They have little relief for start-up and expansion costs and the associated risks, because they receive nominal representation on Capitol Hill. Further, the US Treasury and IRS often see them as “easier pickings” as they traditionally audit the larger of these companies to extract additional tax revenue as often their owners can seldom afford the siege.
So, who stands to gain by closing these loopholes? The politicians, as the number of these families, while over 100,000, is infinitesimal compared to the number of votes of everyone else. However, these families’ personal and company tax revenues are considerable.
What about the US Chamber of Commerce? Does the Chamber’s leadership roster reflect executives from these private companies or larger corporations who would prefer less competition from private companies who are often more nimble and innovative?
What about the Banking, Trust and Life Insurance industries? If the families have to sell their companies to pay the taxes, who benefits? Banks use the cash proceeds if a sale is necessary and collect fees on managing these funds which they often invested in public securities earning a fraction of the returns the private companies did. Insurance companies receive commissions for selling their life products and receiving premiums. If families don’t wish to sell due to a death, then purchasing adequate life coverage in order to pay taxes is a most.
What about the 300,000+ Certified Public Accountants or 100,000+ attorney member associations like the AICPA and ABA whose members have these families as their best clients? Little representation from these professions occurred en masse to challenge Chapter 14. Why would the threat to 2704 differ?
In fact, there was a mad rush of thousands of gifts made before December 31, 2012 requiring untold hourly billings of attorneys and accountants (and yes, business appraisers). The additional complexity of $20 million+ families and their businesses assure more professional billable hours where the tax and asset protection tail often wag the wealth dog.
There is a nascent effort to support a holistic approach to wealth building of alternative assets held by these families by more dynamic leaders in these professions. First, and some might say ideally, they can elect the tax and karma benefit of philanthropy by forming foundations or making charitable donations.
This provides the choice between paying Uncle Sam or the charities of their choosing. Others suggest enhancing the value of their holdings and further increase income by lowering operating risks and offering more options. These options can include selling a minority interest to a family office or private equity group where legacy is preserved, while more liquidity and professional management is achieved.
These activities are often tactical, transactional and technical in nature seldom considering human capital issues of founder and family that are typically intertwined with their businesses, trusted advisors and communities. This is why I wrote the Wiley Book “Equity Value Enhancement: A Tool to Leverage Human and Financial Capital While Managing Risk” to address these challenges and opportunities.
These families’ voices were forgotten during either the DNC or the RNC presidential conventions. The two candidates might be reminded by what was once the well-regarded “Fourth Estate” (media as critical journalism and news versus entertainment). Otherwise, these families stand to lose to short-sighted policies absent the benefit of lobbyists larger institutions exert. These lobbyists seek to further lower public corporate taxes while the public’s focus is diverted on taxes paid by the 1% versus the 99%.
If we like the liberties expressed by our Founding Fathers, we’ll have to learn that citizenship was not intended as a spectator sport. Otherwise, we get the elected officials, the tax, fiscal and regulatory policies we deserve. Teddy Roosevelt was right. “Dare greatly…” Choose to discount the message or the messenger for today’s gratification at the expense of tomorrow’s grief.
RELATED EDUCATION & PRODUCTS
The IRS just released proposed Section 2704 Regulations! These new regulations will severely restrict your and your clients’ ability to utilize deep valuation discounts when doing gift and estate tax planning. Nationally renowned gift and estate tax experts, Bob Keebler and Steve Oshins, are on top of it! Join us for a special presentation to find out more about what these Regs mean and to learn about the HUGE potential planning opportunities! >>REGISTER NOW
ABOUT THE AUTHOR
Carl Sheeler is an “as needed” family office chief-of-staff and strategic value architect (Managing Director at the global, 1,000+ staff, advisory firm- BRG, LLC, where he serves as Global Leader of Family Office & Business Practice.). His stewardship is called upon when returns need boosting, proposals need assessment and plans need timely execution. Projects range from optimizing family holdings’ liquidity, legacy and leverage as well as providing solutions for messy disputes when millions are at risk. After a quarter-century, working with 1,000+ advisors and families, Carl gained the wisdom shared in Equity Value Enhancement by leveraging human and financial capital while managing risk. He was honored as the Midmarket Thought Leader of the Year by the AM&AA and is an Amazon best-selling author. To contact Carl, you may e-mail him at [email protected].
OTHER ARTICLES IN THIS ISSUE
- PRACTICE-BUILDING: The Top 20 Seminar Marketing Mistakes People Make (Part 2 of 2) by Philip J. Kavesh, J.D., LL.M. (Taxation), CFP®, ChFC, California State Bar Certified Specialist in Estate Planning, Trust & Probate Law
- ADVANCED PLANNING: The Private Decanting: A Do-Over Trust with your Privacy Intact by Steven J. Oshins, J.D., AEP (Distinguished)
- SUPPORT & ADMINISTRATIVE STAFF: The Success of Your Business Starts with a Happy Work Environment by Kristina Schneider, Executive Assistant
- TAX PLANNING: Can a Wrong IRA Beneficiary Designation be Corrected After Death? by Michelle L. Ward, JD, LLM, CSEP