All the talk about rising tax rates and lower estate exemptions next year reminded me of my early career. That’s when a sea change of tax changes and popular sentiment seemed to be going against affluent, successful people. Some of you are too young to remember Reagan’s Tax Reform Act of 1986, but it eliminated or reduced the value of many tax deductions, removed millions from tax rolls and reduced the number of tax brackets. Many advisors were slow to react to the changes, and some terrible last-minute planning decisions were made to beat the year-end deadlines.
In many ways, the Biden tax plan isn’t unique. There will always be tax torpedoes fired at high-net-worth taxpayers when the government needs to raise money to fund its popular initiatives. I've lost count of how many tax changes there have been during my career. But as the old saying goes: “History tends to repeat itself.”
I realize the year-end planning agita is not triggered only by a changing tax landscape. Demographics are also at play. Over 3 million baby boomers are retiring every year—about 10,000 per day—and tens of thousands of them are aging out of their businesses. Many of those retiring boomers would prefer to run their enterprises for another four or five years. But if their tax hit five years from now will be a lot worse than it is today, many are asking themselves: “Why don’t I just cash out now and call it a career?”
Further, the lingering pandemic has forced people of all ages to contemplate their own demise. Even folks who are years away from retiring or selling their businesses are thinking hard about their legacies. Legacy planning, combined with a need to mitigate taxes from all kinds of highly appreciated assets, has hastened the need for charitable planning.
Let the Tax Code Be Your Guide
We have a big, hairy complicated tax code, but it’s not necessarily designed to work against you and your clients. If you slow down and use incentives that are clearly written into the law, there are numerous ways to reduce or eliminate taxes for your clients and their heirs. More on that in a minute.
Volumes have been written about ways to mitigate the tax hit resulting from appreciated stocks, bonds and real estate. But, what about those harder to define and value assets? That’s where we see many planning mistakes made.
One of the biggest planning gaps has to do with collectibles. According to UBS data, 25% of HNW investors consider themselves collectors. Whether pursuing artwork, classic cars, planes, antiques, rare coins, vintage wine or other luxuries, those treasures are often purchased for aesthetics and enjoyment. But they are assets nonetheless. Where those assets go when the owner dies is part of the estate-planning puzzle.
Typically, most people purchase collectibles in their own name and own them in their own name. They hang it on the walls of their home, or they park it in a 14-car garage. And when they die, those assets are included in their estate. Those assets aren’t liquid, by the way (unless, of course, they collect wine).
If a client has a taxable estate and the Internal Revenue Service requires them to pay estate taxes within nine months of the date of death, the things that get sold off are the things that no one knows what to do with—that is, the art or the automobile collection from the estate. The collection is from the estate because properly planning wasn’t done beforehand, so the family is selling it to raise money to pay the debt.
Like any other assets, collectibles have tangible value. They need to be valued and planned for properly, especially if the goal is to provide liquidity from within the estate, or to sell them off in a systematic manner that doesn’t depress the market. Or if your clients want their heirs to have certain of those assets, they can't just take them off the wall or drive them out of the garage. They have to have clear title, which means they can't just make them disappear. Unfortunately, this fact often gets overlooked by clients and their advisors.
I had one client with a huge Civil War memorabilia collection worth close to seven figures. Another client owned $1 million worth of antique paperweights. When he passes on, one of his heirs is going to receive $1 million worth of paperweights. Trust me, paperweights aren’t something most advisors pay attention to. If we hadn’t done the right planning upfront, the heir would have been looking at a hefty tax bill.
Crypto Asset Confusion
Crypto is another area that advisors misunderstand. Until recently, many financial advisors scoffed at crypto and nonfungible tokens (NFTs) as not being part of true wealth creation or planning. But, with so many clients coming to them for advice about shielding and transferring their crypto assets, advisors are frantically playing catchup. We're working with several clients who have $20 million to $30 million worth of cryptocurrency. Since the assets are currently in their estate, if they die tomorrow, the IRS will expect to get paid. I'm pretty certain the IRS doesn’t accept cryptocurrency as payment. So, we must help clients come up with real cash—and that typically means finding a way to cash in their crypto.
Now that the IRS has identified crypto as property, it’s considered a long-term capital asset. The good news is that your clients can do several things with it from a charitable planning perspective. They can transfer the crypto as property, for instance. In many ways, NFTs are going to be just another form of art. So, we’ll need to find ways to plan for it and transfer it tax-advantageously.
The big issue with crypto is that no one wants to give up their key. But how do you make an irrevocable gift if the owner won't give up their key? There’s much uncharted territory we’ll have to start navigating as trusted advisors. We can no longer think of ourselves as defenders of a map, but instead as trusted guides through a changing landscape of complex decisions. And by the way, we don’t always have to find the next bright, shiny object that comes down the pike. Sometimes we find new uses for longstanding tools. Take the good old pooled income funds (PIFs).
PIFs are a cure for capital gains hangover. Even if only some of President Biden’s proposed changes to capital gains taxes become law (for example, higher tax rates, carryover basis), PIFs will become an even more attractive strategy than they already are. PIFs are essentially charitable trusts that “pool” together irrevocable gifts from one or more individuals—often a family. Wildly popular when first introduced in 1969, PIFs fell out of favor in recent years because their economics weren’t beneficial to donors. The combination of reduced-tax deductions and more flexible planning tools reduced their broad appeal. However, the tide seems to have turned, with savvy charities working with advisors in establishing new PIFs to take advantage of current, low applicable federal rates—a published federal rate that reflects a benchmark used for many situations, including private loans.
PIFs allow your clients to donate almost any asset—most likely, low-basis stock or low-basis real estate—and receive a charitable income tax deduction. Your clients can then sell that asset inside the PIF and avoid all the capital gains tax on the sale. Donors then receive an income for life. In many cases, PIFs allow your clients to provide income for several additional generations, before the money actually travels to charity. Tools like PIFs circumvent the argument that if your clients give large sums to charity, their children and grandchildren won’t get it.
I've been preaching the PIF gospel for half a dozen years, but only now are advisors hearing the message as the new tax landscape looms. Advisors are calling me with clients completing sales of $10 million, $20 million, even $50 million and asking me if they can use a PIF to mitigate their tax hit.
See my recent article for more about PIFs: Pooled Income Funds Explained
Dealing With Change
The changes ahead won’t be easy, but that's one of the things I love about being a planner. It’s always interesting and ever-changing. What are the best tools to use today, as opposed to what we used five or 10 years ago? We’ll have to keep challenging ourselves to learn new things, to be on top of our game, so that we can deal with whatever comes along.
There’s going to be an extraordinary amount of business out there over the next five to 10 years. I know you’re up for the challenge!