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 is March 2009 marked the lowest decline in public stock market values. It was a key tipping point - perhaps more extreme than the great depression. Much of the wealth derived by these families in attendance were 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. The subsequent benefit of those with work income (most earnings from efforts) were those who remained or returned to the stock market was considerable. Even more so were those with wealth income (most earnings from investments) derived originally from concentrated risk (originally owning a business or real estate).
Not so those in default and those who lost or can’t find well-paying jobs. Many are the disenfranchised that support Donald Trump or supported Bernie Sanders. They’re along the Economic Darwinism bell-curve. The middle-aged who have insufficient savings to retire who slow the upper-mobility of Millennials who boomeranged back to their parents’ homes. The Millennials who can’t make payments on their collective $1 trillion in student loans. Also, fixed-income seniors whose accounts 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 personal credit derived from their homes' equity.
Risk shifting went to the banks carrying the debt on their books. From a simple financial model, debt is cheaper than equity, so the price of stocks were inflated by the leverage. Consumers enjoyed both 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 are these “good times” because of access to 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.
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-2007), then the 3.75% rate buys twice the home. The same holds true for the “cost of capital” to corporations that delevered (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 a suitable?; 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 that are the engine of the U.S. economy who 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 often insufficient for the products these households crave.
The socio-economic implications are huge. In short, where would the stop-gap be for these tens of millions of people 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 taxes revenues that provides our homeland security and national infra-structure for their headquarters, defend the fair-trade of their products and the military to protect their global interests.
Two things were learned from the great recession. The ultra-wealthy ($30 million-plus net worth) questioned the alignment of banking, tax, legal, insurance and wealth management institutions’ motivations and that of their families liquidity, leverage and legacy goals. 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 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 written and 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%. 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 that changed the tax code by instituting Internal Revenue Code Chapter 14.
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 that 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 of Chapter 14 with proposed regulations that include significant restriction and/or elimination of 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 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 and 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, their 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? 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. Alternatively, 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.
What about the 300,000+ Certified Public Accountants or 100,000+ attorney 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?
Little engagement occurred during the possible return to $1 million exclusion. 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 wags 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. (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. They seldom consider the human capital issues of founder and family that are typically intertwined with their businesses, their trusted advisors and their 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. Perhaps one of 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 representing 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.
WSJ Article: http://www.wsj.com/articles/government-aims-to-limit-technique-for-lowering-estate-gift-taxes-1470155292?inf_contact_key=2072ce0ae137718d12be6487eb16afbebfe88c42a886571749c9ddfd3d00104a
Valuation Strategies Article: http://static1.squarespace.com/static/54e65492e4b03ce768a06142/t/57a24547ebbd1adfd69a7204/1470252367822/at+the+crossroads%2C+sheeler%2C+valuation+strategies++nov+dec+2013.pdf?inf_contact_key=65ae7765d8903f70d8cbc4804c1e7017b8076efa8350550e07722b5ee6e712e0
Equity Value Enhancement: https://www.amazon.com/Equity-Value-Enhancement-Leverage-Financial/dp/1118871006