Author: Jesse Mackey

Today’s blogticle concludes our 3 part series on tax efficient investment opportunities. Please see the two previous days coverage for the full story.

Tax Loss Harvesting- A fundamental technique for tax-efficient investment portfolio management that can be used with mutual funds, individual securities, or any other asset that can generate capital gains, is Tax Loss Harvesting – the active realization of capital losses for tax purposes, without incurring an actual loss for the investor’s portfolio. In its simplest form this is accomplished by selling a security that has experienced a loss, waiting thirty days (to avoid the IRS’s “Wash Sale Rule”), and purchasing the same security back in order to regain exposure. The tax loss that is generated as a result can be applied on the investor’s tax return to offset any gains created elsewhere and to claim a loss up to a maximum of $3000 per year, with the balance of the loss to be carried forward for use in future years. In addition to this most basic use of the method, more sophisticated techniques may be used with both mutual funds and individual securities to further minimize/offset taxation and maintain constant market exposure, permitting appreciation that may occur during the 30 days that the investor would otherwise be un-invested.

Mixed Account Type Portfolio Construction – One common technique utilized amongst comprehensive financial planners and investment planners for their clients is appropriate if the investor has multiple accounts with different registration types that are meant for the same investment objective. An example is when an investor has a joint taxable account and an IRA that are both intended to accumulate assets for retirement. In this instance, a single fully diversified portfolio may be constructed with the assets from both of the two accounts. Since some of the assets in this diversified portfolio will be more tax-efficient than others, the planner will purchase the assets that generate the greatest tax liabilities in the tax-deferred IRA account, and the assets that generate the least tax liabilities in the currently taxable joint account. The overall tax bill to the investor will thus be minimized every year.

Tax Transitioning- Tax transitioning is a technique best used when implementing a new portfolio by transferring existing securities holdings from an old portfolio manager to a new portfolio manager. The objective of the technique is to minimize the capital gains tax burden in a single year that might result from the liquidation of low cost basis stock holdings. When an investor owns stock that was originally purchased at a low price and has experienced significant appreciation, the capital gains tax liability associated with selling the entire holding at once may be too much to come up with in that year, especially if the investor has other significant tax liabilities. Therefore, when transferring assets to a new portfolio manager, the investor, in discussion with his/her new manager may decide that it is better to sell only a portion of the highly appreciated stock in the first year, using the proceeds to begin construction of the new portfolio, and then sell the remaining portion in the second tax year (or maybe even again in the third). While this is not optimal from the standpoint of initial portfolio diversification and volatility minimization, it will allow the investor to spread out his/her tax bill for the sale over the course of two or even three years. This technique is most useful if the new portfolio will be initially implemented at the end of the fiscal year, because by waiting only a few weeks until January for the second sale, the second tax bill will not be due until more than a year later, and the entire portfolio may be implemented very quickly.

For additional information contact our panel of experts or the author of this series.

Jesse Mackey is a partner and Investment Officer of 4Thought Financial Group Inc. 4Thought was created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors.

Contact:

Jesse Mackey

4Thought Financial Group Inc.

www.4TFG.com

jmackey@4TFG.com

Life Partners Holdings, Inc. investors have filed a class-action lawsuit against the Waco Texas based life settlement provider, alleging that its directors and officers violated securities laws. The lawsuit comes a month after an announcement was made that the publically-traded company is the subject of an SEC investigation into the life expectancies the company uses to value the life insurance policies it sells to its customers. Life Partners is accused of misleading its customers—investors in life insurance policy—about the life expectancies of insureds on the policies it sells, with insureds outliving the life settlement company’s life expectancy estimates 90% of the time.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of life settlements in Advisor’s Journal, see Life Settlement Provider Accused of Falsifying Life Span Reports (CC 11-23), Life Settlements Funds Performance Fees under Scrutiny (CC 10-116) & Should the Basis of a Life Contract be Adjusted by Mortality Charges? Rev. Rul. 2009-13 Says Yes in Context of Life Settlements; Certain Amounts over Adjusted Basis Treated as Capital Gains (CC 09-19).

For in-depth analysis of life settlements, see Advisor’s Main Library: A—Life Settlements—Introduction.

Why is this Topic Important to Wealth Managers?  A producer should be able to present a perspective of the potential impact of current budget proposals upon investments that will be realized in the future.  Thus, Advanced Market Intelligence discusses certain features to the proposed federal budget that impact fiscal year 2012.

The President’s new budget proposal included many revenue raising measures.  However, below are two areas affecting the tax code that will actually increase the deficit, and also have a strong likelihood to have an impact on clients’ decisions made today.

Currently, the maximum rate of tax on the qualified dividends and net long-term capital gains of an individual is 15 percent. [1] In addition, any qualified dividends and capital gains that would otherwise be taxed at a 10- or 15-percent ordinary income tax rate are taxed at a zero percent rate.

The zero- and 15-percent rates for qualified dividends and capital gains are scheduled to expire for taxable years beginning after December 31, 2012. [2] In 2013, the maximum income tax rate on capital gains would increase to 20 percent (18 percent for assets purchased after December 31, 2000 and held longer than five years), while all dividends would be taxed at ordinary tax rates of up to 39.6 percent.

Taxing qualified dividends at the same low rate as capital gains for all taxpayers is said to reduce the tax bias against equity investment and promote a more efficient allocation of capital.  Eliminating the special 18-percent rate on gains from assets held for more than five years is thought to further simplify the tax code.

The Administration’s revenue baseline budget assumes that the current zero- and 15-percent tax rates for qualified dividends and net long-term net capital gains are permanently extended for middleclass taxpayers.   In addition, the proposed budget would apply a 20-percent tax rate on qualified dividends that would otherwise be taxed at a 36- or 39.6 percent ordinary income tax rate.  This is the same rate as will apply to net long-term capital gains for upper-income taxpayers under current law after 2012.  The reduced rates on gains from assets held over five years would be repealed.  The special rates applying to recapture of depreciation on certain real estate (Section 1250 recapture) and collectibles would be retained.

This proposal would be effective for taxable years beginning after December 31, 2012, and would increase the deficit by $9.582 billion in 2013.

Secondly, the President’s budget calls for the repeal of information reporting on payments to corporation and payments for property (an issue that has been the topic of much discussion lately).

Generally, a taxpayer making payments to a recipient aggregating to $600 or more for services or determinable gains in the course of a trade or business in a calendar year is required to send an information return to the Internal Revenue Service setting forth the amount, as well as name and address of the recipient of the payment (generally on Form 1099). [3] Under a longstanding regulatory regime, there were certain exceptions for payments to corporations, as well as tax-exempt and government entities.  Also, this information reporting requirement did not apply to payments for property.

Effective for payments made after December 31, 2011, the Affordable Care Act expanded the information reporting requirement to include payments to a corporation (except a tax-exempt corporation) and payments for property.  [4]

Generally, compliance increases significantly for payments that a third party reports to the IRS.  In the case of payments to tax-exempt or government entities that are generally not subject to income tax, information returns may not be necessary.  On the other hand, during the decades in which the regulatory exception for payments to corporations has become established, the number and complexity of corporate taxpayers have increased.  Moreover, the longstanding regulatory exception from information reporting for payments to corporations has created compliance issues.   In addition, the expanded information reporting requirements imposed by the Affordable Care Act is expected to put an undue burden on small businesses.

The proposed budget would repeal the additional information reporting requirements imposed by the Affordable Care Act.  Further, the proposal would require businesses to file an information return for payments for services or for determinable gains aggregating to $600 or more in a calendar year to a corporation (except a tax-exempt corporation).  Information returns would not be required for payments for property.

This proposal would be effective for payments made after December 31, 2011, and have a net increase of the deficit in 2012 of $475 million.

Tomorrow’s blogticle will continue with discussion on the national budget.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts

[2] See Section 102 of The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (HR. 4853).

[3] See Internal Revenue Code Section (IRC) 6041, Treasury Regulations (TR) 1.6041-1(a)(1)(i), TR 1.6041-1(a)(2).

[4] See Patient Protection and Affordable Care Act, 124 Stat. 1029.  §9006 (a).

Author: William H. Byrnes & Benjamin S. Terner

Why is this Topic Important to Wealth Managers? Yesterday we presented an overview of the Obama Tax Cut provisions that are relevant to wealth managers.  Today we begin by taking a closer look at some of the details of those provisions and how they relate to wealth managers and their clients.

Section 102 of The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (HR. 4853) provides for an extension of the regular and minimum tax rates for qualified dividend income and capital gains as were in effect before 2011.  The extension will continue for an additional two years.

To understand the impact of this provision of the new bill, it will serve the reader to understand what the regular and minimum tax rates in relation to qualified dividend income as well as capital gains means.

Qualified Dividends

Before the passage of the second major tax cut enacted by the prior administration, The Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends were taxed as ordinary income, and at ordinary income tax rates, to the taxpayer.  With the passage of Section 102 of the Obama Tax Cuts, the determination of tax liability with regards to qualified dividend income is taxed at the same rates as net capital gains.

Therefore, under Internal Revenue Code § 1(h), qualified dividends are tax at zero and fifteen percent.  Qualified dividends that would be taxed as ordinary income at an otherwise 10-15% rate, are taxed at zero percent, and qualified dividends that would ordinarily be taxed as ordinary income at 25% are taxed at a maximum of 15%.

Qualified dividend income, for this purpose means, dividends received during the taxable year from domestic corporations, and qualified foreign corporations.[1]

One important rule to note with regards to qualified dividend income is that shareholders must hold a share of stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date to be eligible for the reduced tax rates. [2]

Ex-dividend date generally means “the date on which the share of stock becomes ex-dividend”. [3] In other words, when a stock corporation declares a dividend, it also states the date of record, upon which the shareholder must own the stock on the company books to be paid the dividend.   “Once the company sets the record date, the stock exchanges or the National Association of Securities Dealers, Inc. fix the ex-dividend date. The ex-dividend date is normally set for stocks two business days before the record date.” [4]

Capital Gains

With the extension of the Tax Cuts, the maximum tax rate on the adjusted net capital gain of a taxpayer is 15%. [5] Adjusted net capital gain means the sum of:

(A) net capital gain (defined below and determined without regard to the calculation of adjusted net capital gain) reduced, but not below zero, by the sum of:
(i) any unrecaptured Section 1250 gain, and
(ii) 28-percent rate gain, plus
(B) qualified dividend income.  [6]

Net capital means the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year.[7] Qualified dividend income was defined above and has the same meaning as applied here.

Section 1250 gains and 28-percent rate gains are defined in Internal Revenue Code Section 1(h) but are beyond the purview of this blogticle.  For additional discussion on Section 1250 and 28-percent rate gains see TAXFACTS 7524:  How is an individual taxed on capital gains and losses? Accessible through AdvisorFX with your online subscription.  For a free trial see AdvisorFX.

Tomorrow’s blog will continue to discuss pertinent provisions of the new Tax Cuts.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] 26 U.S.C. § 1(h)(11)(B)(iii).

[3] 26 U.S.C. § 1059(d)(4).

[4] Securities and Exchange Commission.  Ex-Dividend Dates: When Are You Entitled to Stock and Cash Dividends. http://www.sec.gov/answers/dividen.htm.  Last Accessed 12/19/2010.

[5] HR. 4853, Section 102; 26 U.S.C. § 1(h).

[6] 26 U.S.C. § h(3).

[7] 26 U.S.C. § 1222 (11).

Brokers and mutual fund companies will soon be required to report to their customers and the IRS on the basis of securities sold from customers’ accounts and whether any gain on the sale is a short or long-term capital gain. IRS Commissioner Doug Shulman praised the new rules, saying that “[i]nvestors will now receive the information they need to more easily and accurately report their gains and losses.” Easy access to basis information will save many investors time and money when filling out their tax returns and ensure that the IRS is given accurate information by investors who make securities sales.

The new basis reporting requirements will be burdensome for brokers; the IRS has estimated that the average broker will spend eight hours annually to comply with the requirements. And this year, brokers have the challenge of implementing the systems necessary to comply with the basis reporting requirements by January 1, 2011. We will keep you posted if the IRS releases any additional guidance.

Read this complete article at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

We invite your questions and comments by posting them below or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers?  Provides general taxation of life insurance contracts owned by a third party transferee, including the payment of death benefits as well as sale or exchange gain treatment.     

Today’s blogticle will discuss taxation of life insurance contracts from the purchaser’s prospective. 

As discussed yesterday, an insurance contract that carries a built-up cash value can be loaned against, collected by the beneficiary, surrendered or sold to a third party.   This blogticle deals in particular with payment of the face value to the third party caused by the death of the insured as well as another sale or exchange of the contract by the third party.  

What are the tax implications if the third party collects the death benefits?

As a starting point, gross income includes all income from whatever source derived including (but not limited to) income from life insurance contracts (unless otherwise excluded by law).[1]

Gross income specifically excludes amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.[2] 

Nevertheless, “In the case of a transfer for valuable consideration…the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration paid and the premiums and other amounts subsequently paid by the transferee.” [3]  In other words, the third-party must include the death benefits as gross income over the amount of consideration and any additional premiums paid. 

Moreover, because the collection of death benefits is not a sale or exchange, the collection of death benefits does not qualify for long-term capital gain treatment. [4]   Therefore the amount received over basis is ordinary income. 

What are the tax implications if the policy is sold to a third party?

As a starting point, gross income includes gains derived from dealings in property. [5]

In determining the amount of the gain, the amount realized is taken over the adjusted basis. [6] Amount realized is generally the selling price.[7]  To determine basis, the taxpayer must capitalize the amount “paid to another party to acquire…a life insurance contract”. [8]  Furthermore, any additional premiums paid by a “secondary market purchaser…serve to create or enhance a future benefit for which capitalization is appropriate.” [9]  The basis then for determination of gain purposes is generally consideration paid plus additional premiums remitted. 

In determining the nature of the gain, unlike the ordinary income resulting from collection of the face value of insurance contract, this situation involves an actual sale of the contract. “Nevertheless some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.” [10]

The “substitute for ordinary income” doctrine is limited in application “to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract).”  Therefore, the amount up to cash value, is taxed at ordinary income and if any amount “exceeds the ‘inside build-up’ under the contract, the excess may qualify as gain from the sale or exchange of a capital asset.”  [11]  Additionally, if the contract is held for more than one year, it would qualify for a long-term capital gain treatment. [12]

Tomorrow’s blogticle will continue the discussion of the taxation of life settlement agreements. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[1] 26 U.S.C. § 61(a); 26 U.S.C. § 61(a)(10).

[2] 26 U.S.C. § 101(a).

[3] 26 U.S.C. § 101(a)(2). 

[4] Revenue Ruling 2009-14. 

[5] 26 U.S.C. §  61(a)(3). 

[6] 26 U.S.C. §   1001(a). 

[7] 26 U.S.C. §§ 1001. 

[8] Revenue Ruling 2009-14, cting CFR 1.263(a)-4(c)(1)(iv)

[9] Revenue Ruling 2009-14.  

[10] Id. 

[11] Revenue Ruling 2009-13, citing e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n. 3 (4^th Cir. 1960).

[12] 26 U.S.C. §§ 1001.

Why is this Topic Important to Wealth Managers?  Provides general taxation of life insurance contracts that are surrendered, sold or exchanged.  Gives examples that are easy to follow and provides an educational foundation for real-world gain determinations.   

This is a two-part series in relation to the taxation of life insurance contracts once it is surrendered, sold or exchanged to a third party.  The first blogticle will examine the issue from the seller or insured’s perspective, and tomorrow’s blogticle will discuss the matter from the purchaser’s prospective. 

An insurance contract that carries a built-up cash value can be loaned against, collected by the beneficiary, surrendered, or sold to a third party.   This blogticle deals in particular with the sale or exchange of the contract, i.e., surrendered or sold. 

What are the tax implications if the life policy is surrendered?

As a starting point, gross income includes all income from whatever source derived including (but not limited to) income from life insurance contracts (unless the income is otherwise excluded by law). [1]

In general, a life insurance contract that is not collected as an annuity is included in gross income in the amount received over the total premiums or consideration paid. [2]  “The surrender of a life insurance contract does not, however, produce a capital gain.” [3] The amount collected over basis is therefore ordinary income. 

What are the tax implications if the policy is sold to a third party? As a starting point, gross income includes gains derived from dealings in property. [4]

In determining the amount of the gain, the amount realized is taken over the adjusted basis. [5] Amount realized is generally the selling price and the adjusted basis is generally the cost of the property. [6]

 “To measure a taxpayer’s gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.” [7]

For example if A receives $80,000 from the sale, and has paid $64,000 in premiums and the cost of insurance to date is $10,000 A must recognize $26,000 on the sale of the life insurance contract to B, which is the excess of the amount realized on the sale ($80,000) over A’s adjusted basis of the contract ($54,000). [8]

In determining the characterization of the $26,000 as either ordinary income or capital gain, unlike the ordinary income resulting from surrender of a life insurance contract, this situation involves an actual sale of the contract. “Nevertheless some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.” [9]

The “substitute for ordinary income” doctrine is limited in application “to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract).”  “Hence, if the income recognized on the sale or exchange of a life insurance contract exceeds the ‘inside build-up’ under the contract, the excess may qualify as gain from the sale or exchange of a capital asset.” [10]

Resuming the example from above, “the inside build-up under A’s life insurance contract immediately prior to the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid).”  Therefore, “$14,000 of the $26,000 of income that A must recognize on the sale of the contract is ordinary income under the ‘substitute for ordinary income’ doctrine.” Nevertheless, “the remaining $12,000 of income is long-term capital gain”. [11]

Tomorrow’s blogticle will continue the discussion of the taxation of life settlement agreements. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[1] 26 U.S.C. § 61(a); 26 U.S.C. § 61(a)(10).

[2] 26 U.S.C. § 72(e)(2); 26 U.S.C.§ 72(e)(5)(A). 

[3] Revenue Ruling 2009-13 citing, e.g. , Rev. Rul. 64-51, 1964-1 C.B. 322. 

[4] 26 U.S.C. §  61(a)(3). 

[5] 26 U.S.C. §   1001(a). 

[6] 26 U.S.C. §§ 1001, 1011, 1012 1016. 

[7] Revenue Ruling 2009-13.

[8] Id. 

[9] Id. 

[10] Revenue Ruling 2009-13, citing e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n. 3 (4^th Cir. 1960).

[11] Revenue Ruling 2009-13 citing, e.g., “within the meaning of 26 U.S.C. § 1222(3).”