By Bill Rudnick, Senior Partner, General Counsel & Co-Head of Family Office Services; Sarah Simon, Director, Wealth Strategist and Wealth Advisor; and Josh Kanter
The accumulation of wealth can be freeing in many ways. For many families, it allows them to enjoy the lifestyles they have long desired. However, with wealth can also come complexity.
There is the complexity that comes with managing wealth itself: investment strategies, estate planning, tax strategies, etc. Families of wealth often must conduct a detailed cost-benefit analysis on what can be a multitude of options. Consider an outright gift versus an estate freeze. While an outright gift may be the simpler option to pass down wealth to younger generations, an estate freeze allows for assets given to heirs to grow without any tax consequence to the person making the gift. However, an estate freeze comes with the “cost” of needing to set up a receiving entity and make decisions on issues like governance, distributions, succession, etc.
When weighing the pros and cons of financial strategies, families should not only consider the potential financial benefit / cost of a proposed strategy, they should also consider the cost in terms of the complexity it could add to their lives.
That cost could include significant time and resources to adequately comprehend what can be very complicated concepts, the need to educate the broader family, and the added stress that a proposed strategy can add to one’s life. Also, all that complexity may be passed down to future generations when it is their turn to manage the family’s wealth. Will your heirs have the capacity and interest to do so?
The following are three examples of strategies that present families with a choice between complexity of structure and complexity of life:
Profits Interest Structure
Families and family offices often struggle with the deduction limits of various investment expenses. One potential solution to that problem is the creation of a so-called profits interest structure. Essentially, the family creates an entity that serves as an investment advisor for the family. That new entity receives a profits interest (or equity stake) in the family’s investments.
The tax benefit of creating a profits interest structure can be material for some families and family offices, but so, too, can be the complexity it adds to a family. For example, the family will need to make decisions around the ownership, structure, and operation of this new entity. A profits interest structure requires a great deal of accounting and administration year after year.
Malta Pension Plans
When you have an asset that has appreciated significantly, and you want to maximize capital gains tax savings, a Malta Pension Plan (MPP) may be advantageous to explore. The MPP takes advantage of the U.S.-Malta Tax Treaty and allows individuals to provide for their retirement in a tax-deferred vehicle beyond what can be achieved via traditional retirement plans such as IRAs or 401(k)s. It can be particularly beneficial to fund an MPP with highly appreciated property. That is because unrealized income, capital gains, and recapture taxes are not triggered by the contribution to an MPP.
For example, let’s say you own stock that is worth $50 million and has almost no basis. If you contributed this asset to an MPP, you could immediately sell and diversify without being subject to capital gains tax. If the proper distribution rules are followed, you may begin taking a 30 percent distribution tax-free as soon as 12 months after the initial contribution, assuming you are over age 50. You must wait an additional three years for subsequent distributions.
However, an MPP adds complexity in that it requires additional accounting, administrative, trustee, and legal costs, as it is treated as a foreign grantor trust. In addition, there is always the risk that the U.S.-Malta Tax Treaty could be amended, which would certainly complicate things. It is important to evaluate whether the costs and administrative responsibilities of employing this strategy outweigh the benefit to your family.
Private Placement Life Insurance
Private Placement Life Insurance (PPLI) provides a tax-free insurance “wrapper” with greater access and choice in investment strategy than retail life insurance. More specifically, PPLI is a type of variable universal life (VUL) insurance that allows investments contained within the policy to grow, all while the income and capital gains taxes are deferred. Ultimately, these gains can be received income tax free at the passing of the insured in the form of a death benefit if the assets are owned by a properly structured insurance trust and all the rules are followed. If structured properly, individuals have the flexibility to make premium payments with public or private investments, as well as cash contributions.
Given both current tax rates and expectations around a potential increase in future tax rates, this can be a very advantageous strategy to invest in more tax-inefficient investments like hedge funds.
However, PPLI has both legal and administrative costs, as well as diversification requirements. It is important to be comfortable meeting the diversification criteria of having at least five investments, with no one investment being more than 55 percent of the value of the policy.
The tax benefits of PPLI can be significant, particularly for clients in high income tax states, but it is important to consider whether this strategy is aligned with the objectives of the family and the appetite for complexity.
There are many more examples of financial strategies that require a thoughtful cost-benefit analysis. The key is to have experienced advisors you trust by your side to help guide you through the process, as there are rarely “off-the-shelf” solutions. With the right team of advisors in place, you can indeed strike the balance that is right for you and your family.
