Archive for category: Wealth Transfer Strategies

Liquidity is NOT a Benefit

Categories: Investment Strategies, Wealth Transfer Strategies

I continue to see many references to liquidity touted as an investment benefit.  In fact, it’s often suggested to be the most important benefit when considering different investment choices.  It’s mentioned as such in news articles, online discussions and even some conference presentations.  This is unfortunate for the advancement of industry knowledge and understanding because frankly, it’s wrong.  Especially considering that most references of this type also declare illiquidity as an automatic detractor.

The amount of liquidity inherent in a particular investment is merely a FEATURE.  It is not specifically a benefit or detriment.  Some investments have high liquidity in that they can be traded most days on open exchanges.  Others do not trade at all and still more have various limited liquidity options via redemption or buyback programs.  In each case, the particular liquidity of the asset is merely a feature specific to that asset.

Assume Bill has one million dollars cash.  No argument that his portfolio is completely liquid.  His friend Kevin owns a local McDonald’s restaurant franchise for which he paid one million dollars.  Since the restaurant is wholly owned by Kevin and does not trade on an exchange, he “suffers” from complete illiquidity.  Who is better off?  No doubt some will say Bill, others will say Kevin (especially those who enjoy a Big Mac now and again) but many will come up short in trying to choose between the two.

If liquidity is the most important consideration, or at least the initial and primary consideration before looking at asset type and other criteria, then shouldn’t Bill automatically be in the best position?  Yet no one would advocate holding all of one’s assets in cash to satisfy the liquidity-is-best mantra.

Lest anyone think I’m not being fair because Bill holds cash and doesn’t really have an investment to compare, let’s change the scenario a bit.  Bill now buys one million dollars of publicly traded McDonalds Corporation stock.  Who is better off in this new scenario?  It is impossible to answer on the grounds of liquidity alone which is how many outlets try to frame the issue.

The fact is that both investments have benefits and deficiencies based on their liquidity FEATURES.  If Bill simply holds the shares for five years, he has realized no benefit from the fact they could have been sold during that time.  If Kevin keeps the restaurant five years, then just as Bill did not realize a benefit from the liquidity of his shares, neither does Kevin realize a detriment from the illiquidity of his franchise.  That eliminates the argument referenced in the first paragraph that liquidity is always a benefit and illiquidity always a detractor.

Liquidity is the feature that affords the benefit of being able to reallocate monies to other priorities quickly.  A client with fifty thousand dollars of a liquid investment may decide she would rather apply those funds toward a new automobile.  The liquid nature of the investment provides her the opportunity to move quickly.  Again, liquidity is the feature, buying the automobile when she desires is the benefit.  Similarly, she may own fifty thousand dollars of an illiquid investment which she desires to transfer to her grandchild as a gift.  She does not want the grandchild to be able to convert the asset to cash right away and spend the money foolishly.  Thus, illiquidity is the feature and protecting the grandchild from being a spendthrift is the benefit.

The real underlying questions of whether a particular investment is appropriate for a particular investor must go much deeper than one specific feature of said investment.  Investments are simply tools used to accomplish various financial results.  Just as carpentry tools have different features allowing them to provide different benefits (hammers pound nails, saws cut wood, etc.), so it is with investments.  Degree of liquidity is merely an investment feature providing different benefits which must be weighed together with myriad other criteria when selecting appropriate holdings for specific clients.  When you hear someone demonize an illiquid investment and glorify a liquid one, please help set the record straight and frame the issue properly.

Author: Joe Luby, CFP®

©2012 All rights reserved.

Who Cares About the AI Market? You Should.

Categories: Education and Resources, General, Investment Strategies, Wealth Transfer Strategies

Dear Friends & Colleagues,

I had an interesting conversation this week.  The founder of an RIA firm in the Midwest contacted me to discuss the concepts outlined in our latest white paper.  The paper is titled “Acres of Diamonds – How to Double the Size of the Alternative Investment Market” and can be downloaded for free here.  Even more interesting is the fact that this firm does not currently use many alternative investments (AI) in their client portfolios.  Why did they read a report about increasing the AI market?

The title may not be catching for attorneys, CPAs and financial advisors thinking “who cares about the size of the alternative investment market.”  However, once you understand the concepts presented, you will scramble to help increase the size of the AI market.  Many will demand more AIs for their clients specifically for the planning opportunities presented.

The call from the RIA firm this week proves my point.  They read the white paper and wanted to know which AI companies followed the policies highlighted in the report.  Specifically, they wanted to talk to those AI firms about starting to allocate significant client funds to their products!  The piece definitely struck a chord with this advisory firm once they realized the amazing financial and tax planning opportunities for clients holding AIs.

And that’s the point.  Attorneys, CPAs and financial advisors who understand the financial and tax planning opportunities hidden within the AI market demand more of these assets for their clients.  So take a look at the white paper and see if some of the concepts strike a chord with you and how they may fit into your client scenarios.

Best Regards,

Joe Luby


Turbocharge Your ILITs

Categories: Wealth Transfer Strategies

The irrevocable life insurance trust (ILIT) is one of the most common planning techniques used to provide income and estate tax-free liquid assets for beneficiaries.  Generally, the grantor(s) will make annual gifts to the ILIT intended to cover the premiums on the life insurance policy owned within the trust.  Using Crummey provisions included in the trust document, the grantor(s) will apply their annual gift exclusion to the premium gifts to the ILIT.  This is fine as long as the premiums fall within the annual exclusion amount and the grantor doesn’t want to use the exclusion for other gifts during the year.

Problems can arise when the premium cost is greater than the available annual gift exclusion or in other scenarios where the grantor has issues with making the premium payment.  Try this unique solution for new and existing ILITs:


  1. Grantor buys or already owns Jagen™ fund holdings with net asset value (NAV) of $1 million and fair market value (FMV) of $700,0001 and a three year fund term.
  2. Grantor sells his/her Jagen™ fund holdings to the ILIT for full FMV of $700,000 in exchange for an interest-only promissory note.
  3. ILIT repays note principal of $700,000¹ out of full NAV proceeds ($1 million²) when the Jagen™ fund term expires in thirty-six months.
  4. ILIT then has $300,000 in cash to use for annual premium payments, to purchase a paid up policy or other uses.  Cash could also be used to repay a premium finance loan if the ILIT had incurred such debt previously.
  5. Future ILIT premiums and other expenses have now been “pre-funded” with $300,000 cash with zero gift tax liability or Crummey notice requirements.

This is just one of multiple applications for Jagen™ funds that can greatly enhance clients’ existing or new planning strategies.  Call or email today for more information and to discuss specific client case situations.

¹Discount for illustration purposes only.  Actual discount, if applicable, will vary.

²Assumes no change up or down in NAV during the stated holding period.  Actual results will vary.

© 2010  Jagen™ Investments, LLC

Using Qualified Disclaimers as a Hedge for Tax Uncertainty

Categories: Wealth Transfer Strategies

Using Qualified Disclaimers as a Hedge for Tax Uncertainty – Wealth Strategies Journal 2.0 (Beta)
As Seen In Wealth Strategies Journal, October 2010
Article By: Joe Luby, CFP®

Use this simple and unique solution to add flexibility in dealing with estate tax uncertainty

What a remarkable time to be in the business of advising wealthy families on financial, tax and estate issues! It’s remarkable both in terms of the changes and significant developments in the field, as well as for the opportunity afforded us as advisors to set ourselves apart and proactively solve client concerns. Many practitioners are hamstrung this year with indecision, worry and fear about what may or may not happen with income taxes, estate tax, generation-skipping transfer (GST) tax, etc. It’s unfortunate for their clients because we’re situated in the perfect tsunami of wealth transfer opportunities. Asset values are way down, tax rates are the lowest they’re going to be in most of our lifetimes and interest rates are near zero. Wealth transfer strategies should be on the top of advisors’ minds right now.
As of this writing, it doesn’t look like Congress will act anytime soon on estate tax reform legislation. Common expectations in the industry expect Congress to eventually enact some version of the law we had in 2009, perhaps with some minor variations. No one knows for sure, but that seems to be the consensus lately. One fear commonly expressed by practitioners nationwide is that Congress could try to enact retroactive legislation and thereby disrupt any transactions put in place today. For example, if they retroactively raised the gift tax to 45 percent or 55 percent from the current 35 percent, then gifts made today become more expensive. The same fear applies to a retroactive GST tax, which could create a double whammy for gifts made in 2010.

Simple Solution
There’s a simple but unique solution to these concerns: the qualified disclaimer (QD). In short, to be a QD under Internal Revenue Code Section 2518(b), the QD must:

· be in writing; and
· be made within nine months of the date of gift or the date the recipient reaches age 21, whichever is later.

Additionally, the recipient may not have accepted the gift, used the gifted asset(s) or benefited from them. The recipient may not direct where the gifted asset(s) goes upon receipt of the QD (that is, the gift either reverts back to the giver or to the next designated beneficiary, if applicable).
Most of us think of QDs for post-mortem planning opportunities. For example, the primary beneficiary of a retirement account may use a QD to redirect the funds to the contingent beneficiary for a variety of reasons. Or, a surviving spouse may use a QD for all or some of the assets in a disclaimer trust,” which specifically incorporates the QD as part of the upfront planning.
In 2010, clients can use QD planning for lifetime gifts to add flexibility and a solution to the issues described above. Taxable gifts made between now and Dec. 31 are subject to the current gift tax rate of 35 percent under 2010 law. If we wait to see whether Congress acts retroactively with an increased gift tax rate or GST tax, we will wait ourselves and clients right into 2011 when we know the rate is scheduled to go up. The time to act is NOW. Clients can use the QD procedure to undo the gift later, should Congress enact a retroactive tax increase.

Take the following example: Tom Clark would like to gift $2 million of marketable securities to his son Bill. He establishes a trust naming Bill as primary beneficiary and his wife, Mary Clark as contingent. The trust is drafted to qualify as a completed gift for tax purposes, and Tom funds the trust with the $2 million securities portfolio. The family now has nine months (assuming Bill is age 21 or older) to decide if they want the gift to stand. Should Congress enact a retroactive increase in the gift tax, Bill will simply disclaim his interest in the trust, which then flows to Mary as contingent beneficiary. The entire transaction is gift tax-free if this option is triggered since the gift is now between spouses. And if the gift tax rate isn’t increased retroactively, the Clarks have locked in the lower gift tax rate by completing the transaction in 2010.
The same set of circumstances applies to gifts made to grandchildren in the event a retroactive GST is enacted. Grandparents can use this opportunity to shift significant wealth using the reduced gift tax rate in effect for 2010 and no GST tax, while still retaining flexibility in their planning if necessary to undo the gift.
Additional opportunities are present when using QD planning this year as well. Assume Congress doesn’t act retroactively and thus the current 2010 gift tax rate of 35 percent applies. However, Tom’s $2 million portfolio suffers significant losses and drops significantly. The QD option allows the family to reconsider whether paying the gift tax on $2 million (even at the lower rate in 2010) is really the best strategy. It may make sense to undo the gift via QD and structure a new gift of the now devalued assets, even though the nominal tax rate may be higher in 2011. If the assets are depressed in value already due to market turmoil over the last few years, the reverse may apply. If the $2 million portfolio recovers significantly in value, the family wins by having locked in the gift now in 2010 at the lower value and reduced gift tax rate.

Discounted Value Assets
Lastly, any gifting strategy using QDs can be greatly enhanced with the use of discounted value assets. The net after-tax impact of the gifting strategies described above is even higher when the asset gifted is subject to valuation adjustments. Examples of such assets are fractional real estate interests, closely held business interests and private investment funds. For example, an asset subject to a 30 percent discount results in a net effective federal gift tax rate on the full asset value of less than 25 percent. So not only can the client lock in 2010’s lower gift tax rate with the flexibility to undo the transaction later, but also he can even reduce the effective rate via proper advanced planning.

Valuation Adjustments – An Opportunity for Planners

Categories: Wealth Transfer Strategies

As Seen In NAPFA Advisor, June 2010
Article By: Joe Luby, CFP®

Valuation adjustments, often referred to as “discounts,” should be on the strategy list of every comprehensive planner. They can provide amazing tax efficiencies for clients, offer opportunities to collaborate with other professionals and allow the planner to bring an advanced planning technique to high net worth clients and prospects.
Traditional securities, such as stocks, bonds and mutual funds, are easily valued due to the liquid nature of their markets. Other non-traded assets are a little more difficult. What is the current fair market value (FMV) of your client’s real estate holdings? What is the current FMV of the partnership interest they own with their golf club buddies that invested in a private placement startup company? What is the FMV of your client’s personal business? See what I mean.
The FMV of these assets is important for a number of reasons. It directly affects your clients’ net worth statement. It affects their total estate value and the gift tax value when these assets are transferred to other family members and/or charity. It affects business transition and succession planning including the possible sale of a family run business. It could impact their liquid securities portfolio allocation. However, I submit that very few clients, much less their advisors, know the FMV of these assets or even a close approximation thereof.
Why not? Much of it has to do with an unspoken cost/benefit analysis. If a client isn’t considering the sale of a particular illiquid asset such as an apartment building, then knowing that asset’s current FMV may not seem important and thus not worth the expense of an appraisal. The same thinking applies to their personal business. Does it really matter if the business is worth $8 million or $10 million today assuming no pending sale or transfer activity? Maybe not, but how does one plan for the long-term financial security of the family if they don’t know the value of all the assets at their disposal?
Dr. Carl Sheeler, valuation expert and managing partner of Alison Appraisals and Assessments, Inc. in San Diego, has an interesting view on this topic. He gives presentations around the country about business valuation and often raises the question: how does one manage the liquid assets for a business owner without taking into account the value of the business from a prudent investor viewpoint? Dr. Sheeler also gives multiple examples of how performing a current business valuation and analysis has lead to significant opportunities to increase the value of the business by finding areas of weakness and improving them.
The FMV of an illiquid asset must be determined by a qualified appraisal as defined in the tax code. The qualified appraiser must take into account relevant factors that may impact the FMV of the asset being valued such as whether it is readily marketable should the owner wish to sell. The appraiser must consider the asset’s liquidity and whether the owner has a controlling interest which allows them to force distributions or otherwise control the management and operations of the asset. These are the three most common principles that give rise to a valuation adjustment or discount: lack of marketability, lack of control (minority interest) and lack of liquidity. There are other factors that apply in various circumstances, but these are the most common and universal. Assuming a minority interest in an illiquid non-traded asset, it is very likely that the appraiser will report a FMV that is less than net asset value (NAV) or book value.
Assume your client Bill owns 25% of a small manufacturing firm. The other 75% is owned in equal parts by three of Bill’s college buddies. They started the company together in their senior year and have been in business for 15 years. The company is profitable and growing. Bill decides to cash out by selling his minority stake and move to the mountains to become a ski bum. On paper, the book value of the company is $10 million, meaning that Bill’s stake is theoretically worth $2.5 million. But can he actually sell it for $2.5 million?
The three partners don’t want Bill to leave the company and also don’t have the means currently to buy him out. So Bill must find a buyer for his interest. After several months of putting out feelers, he finally has someone interested. However, they will not pay Bill’s asking price of $2.5 million and instead demand a FMV analysis. The qualified appraiser reviews the company in great detail including the history of the firm, the projections for the future, any contractual obligations between the partners which may be defined in the partnership agreement (LP) or operating agreement (LLC) or other documents (C or S corporation). The appraiser takes into account that the new buyer will be purchasing a minority interest in the company and will not be able to out vote the three close college friends that have been in business together for 15 years. The new buyer will not easily be able to convert his ownership to cash should he decide to sell at a later date. Thus the appraiser’s FMV report comes back reflecting a 50% valuation adjustment or discount and quotes the current FMV of Bill’s 25% stake as $1.25 million.
This is usually where negotiations between Bill and the potential buyer will begin. Bill may argue for higher than $1.25 million due to a variety of factors such as future cash flows, business opportunities or growth forecasts, etc. Whatever number they agree on will be the true FMV of Bill’s interest. The appraisal was the best estimate absent any actual sale transactions to compare.
How can we use this knowledge and opportunity for clients? Knowing that illiquid assets may be subject to substantial discounted valuations, planners can assist clients in a variety of wealth transfer situations to reduce the tax impact that would otherwise apply. For example, assume Bill was not selling his interest but rather transferring it to several trusts for his children’s benefit and assume that gift tax would normally apply. In the example above, Bill is able to use the lower $1.25 million figure for reporting the value of the gifts rather than the $2.5 million book value, saving him one half the gift tax due.
The most common application of valuation adjustment principles is by use of a family limited partnership (FLP) or family limited liability company (FLLC). These entities are regular LPs or LLCs except they are owned entirely within a particular family (i.e. no outside non-family partners or members). The common scenario has Mom and Dad, the senior generation family members and source of wealth creation, establish the FLP/FLLC and transfer various assets into it. Typical holdings include real estate, family businesses, other partnership interests, securities portfolios, etc. Mom and Dad then transfer minority interests in the FLP/FLLC via gift or sale to various children, trusts and/or charities. Prior to the transfer they retain a qualified appraiser to perform an analysis and determine the FMV of the minority interests to be transferred.
The same valuation adjustment principles described above apply to these interests. Lack of marketability, lack of control (minority interest) and lack of liquidity all factor in to the FMV report for the FLP/FLLC interests. Adjustments or discounts in the range of 25% to 50% are common on these assets.
FLPs/FLLCs can be combined with numerous other wealth transfer techniques to maximize the benefit from the valuation adjustment. For example, a client may transfer discounted assets to a charitable lead trust (CLT) that has been “zeroed out” for gift tax purposes meaning that no taxable gift is made upon funding the trust. The client’s children or trusts for their benefit might be the final principal beneficiary of the CLT. Any amount above the discounted FMV will ultimately pass tax free to the heirs. Discounted assets can be used to fund grantor retained annuity trusts (GRATs) in the same fashion.
Another common scenario involves the sale of discounted assets to intentionally defective grantor trusts (IDGTs). As a grantor trust, the tax consequences of activity in the trust flow back to the grantor. So the sale of assets from the grantor to the trust does not result in a taxable event, nor does interest paid on a note from the sale generate taxable income since the grantor is selling an asset to himself for tax purposes. The IDGT will typically have the grantor’s children as beneficiaries. Instead of gifting assets to the trust and incurring gift tax or using up the grantor’s lifetime gift tax exemption, the grantor will sell minority interests in the FLP/FLLC to the IDGT in exchange for a promissory note payable over a term of years. The sale price is the FMV as determined by the appraisal rather than NAV or book value of the FLP/FLLC interest.
For example, assume a 10% FLP/FLLC interest with a book value of $1 million. The FMV as determined by qualified appraisal reflects a 40% adjustment down to $600,000. The client will sell the FLP/FLLC interest to their IDGT in exchange for a promissory note of $600,000. The additional $400,000 of value is effectively passed tax free to the next generation.
Planners and clients can also use private investment fund structures such as those offered by Jagen™ Investments to achieve the same type of discounts. Private investment funds apply the same valuation adjustment principles found in FLPs/FLLCs without the hassle of forming, funding and managing a FLP/FLLC. The administration and qualified appraisal process are handled at the fund level which saves the client and their advisors time and money. In addition, these funds are typically IRA compliant which means clients can get discounted valuation advantages on Roth conversions and other IRA distributions reducing the tax impact of those transactions.
The devil is always in the details so you must ensure that you work with very qualified advisors including attorneys and CPAs who understand this area in depth. There are common mistakes to avoid and many best practices to implement in order to achieve the desired outcome for your clients. These are important because the IRS, for obvious reasons, is not a fan of valuation adjustments and loves to challenge them when possible. Assuming the proper steps are taken in establishing and operating the FLP/FLLC, it often comes down to an argument over what the FMV really is. In many cases this results in a judge trying to decide between the taxpayer’s valuation expert and the IRS’ appraiser, where the judge must determine whose valuation analysis is most accurate. It is not uncommon for judges to find the actual FMV somewhere in the middle between the two experts numbers (i.e. taxpayer’s appraiser says 45% discount, IRS’ appraiser says 15% discount, judge goes with 30%).
This may also be the best time to implement valuation adjustment strategies with high net worth clients because we don’t know what Congress will do with the estate tax just yet. There are proposals floating around that would limit or disallow discounts in various circumstances. If you have clients and prospects that could benefit from discount valuation planning it is best to move quickly to implement these strategies ahead of any potential changes down the road.

Intra-family Loans in Today’s Low Interest Rate Environment

Categories: Wealth Transfer Strategies

As Seen In The WealthCounsel Quarterly
October 2010
Article By Joe O. Luby III, CFP®

Various planning techniques are more in favor during periods of low interest rates such as we are experiencing in the US today. One of these strategies involves the use of intra-family loans to help shift wealth from one generation to the next with little or no transfer tax impact.

The current applicable federal rates (AFRs) for short-term, mid-term and long-term loans are 0.53%, 2.18% and 3.79% respectively (August 2010). In short, if the investment or asset transferred can outperform these extremely low rates, the clients win big.

Consider the following straightforward example: Mom sells a rental property to son for full fair market value of $100,000 and takes back a promissory note in that amount. The note has a twenty year term and thus uses the long-term AFR of 3.79%. The “cost” of this wealth shift to the son is the annual interest payment on the note. There is no gift tax consequence and the asset is removed from Mom’s estate for estate tax purposes. This is also known as an asset “freeze” technique because all future income and capital appreciation on the property are outside of Mom’s estate. The amount included in Mom’s estate calculation has been “frozen” at the current value of the promissory note but never more than $100,000. Assuming the net rental income and long-term capital appreciation on the property exceed the low AFR in effect, the transaction is a success.

Outperforming the AFR is a key component in these scenarios because it is the excess growth in asset values and future income post-transaction that is being shifted without transfer tax. That is why these strategies are so attractive today. It’s much easier to outperform a rate in the 2%-3% range than one in the 7%-8% range for example.
An even more powerful application of the intra-family loan strategy is the sale of discounted assets. These can be closely held business interests, partial interests in real property, fractional interests in other property or assets such as airplanes, private investments such as Jagen funds, etc.

For example, Dad owns a mid-size manufacturing concern and daughter works for said company. Dad sells a ten percent stake in the company to daughter in exchange for a promissory note at today’s long-term AFR of 3.79%. The ten percent interest in the company has a book value or net asset value of $1 million, but due to typical valuation adjustment factors such as limited liquidity, lack of marketability and lack of control (minority interest) a qualified appraisal reflects a fair market value of only $650,000 (35% adjustment). Thus the promissory note reflects $650,000 – fair market value. When the transaction is complete and the note satisfied, any value above $650,000 is essentially a tax-free gift to daughter. Dad has removed the asset and any future growth in value from his estate. The promissory note “freezes” the estate tax value of the asset at $650,000, or less depending on when Dad dies and how much principal may have been repaid on the note by then.

As with any technique, there are multiple variations on the same theme. In each of these cases the buyer could be a trust or trusts rather than the children personally. Depending on the asset sold and the relationship with the buyer, these transactions can also be a way for the senior generation to begin teaching the adult children about asset management, investing, the family business, real estate management and the competent handling of wealth. Mom and Dad can help guide son or daughter with the management of the asset purchased which can prepare them for a larger inheritance later on.

These are two simplified examples of how to use today’s low interest rate environment to motivate clients to action and produce excellent long-term results for their family. We often hear that clients are sitting on the fence until something more permanent is done on the estate tax. Bringing these techniques to the table can get clients to take action today that will be beneficial regardless of what happens to the estate tax.

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