Personal Wealth Law News

It isn’t Bernie Madoff or the legion of individual advisors who have adopted his business techniques. It isn’t even the US Congress.

It’s health care. It’s the cost of health care, plus the complexity of dealing with our health care/health insurance system, plus time we will spend dealing with these problems.

It is no surprise to anyone that we have a complex health care delivery system in the US. We have excellent medical care, for most of us, but at a substantial cost in money and time.  At my law firm, we have a staff of people who deal with problems that come up regarding our health insurance coverage, and a committee whose task is deciding how we will deal with the constantly-increasing cost of medical coverage.  But it didn’t strike me that this was as great a problem in retirement until I interviewed a retired partner from my firm for a PBI seminar on retirement for lawyers.  This lawyer didn’t have any particular health problems, but he said that he spent a great deal of time in retirement dealing with health insurers and Medicare.  Health care in retirement is a complex system of programs and insurance, and it can be very costly.  He added that the biggest problem of people who retire comfortably in their mid to late 60s is that they will start to run out of money in their later 70s.  They are still probably better off than most retirees, but their plans for a comfortable retirement and to have something to pass on to children and grandchildren could be frustrated by the increasing costs of health care.  And it’s possible that those costs could increase further if the Medicare and Medicaid programs are cut back. 

In the future, a component of retirement and estate planning will have to be planning for health care in retirement in ways that do not bankrupt people or result in their having nothing left to pass on to the next generation.  There’s a business opportunity here: as an adjunct to planning to have a comfortable financial retirement and nest egg to pass on, a business model is needed to provide good medical care at reasonable prices in retirement. 

(Reprinted by permission of the Legal Intelligencer)

This might be a good time to emphasize that it’s a trust fund.

The concept of one person or institution holding money in trust for someone else has been around for centuries.  Apparently, some people have misplaced their copies of Scott on Trusts and decided that being a trustee means you can pretty much do whatever you want, and pay a little or a lot of attention to your duties, as you see fit.  As a result, we have read reports of breathtaking embezzlements and inattention to trustee responsibilities, leading to failure of the purposes for which the trusts were set up.  But we don’t read in the popular press of less obvious wrongdoing, which can be equally damaging.

Here’s an example: an individual establishes a trust for the benefit of his descendants, and he funds it with stock of the company at which he spent his career.  He names two good friends as the trustees.  Over time, one of the trustees loses interest, and defers to the decision-making of the other trustee as to how the trust should be funded.  That trustee decides that since the settler funded the trust with a single stock, it should remain invested in that stock, despite the passage of many years and changes in the nature of the company.  In doing so, both trustees violate their duties, as well-defined in Pennsylvania law.  After some number of years, the beneficiaries begin a barrage of requests that the trustees diversify, which they refuse to do.  Naturally, the value of the company’s stock declines precipitously.  The trustees have failed to act prudently, which is the standard applicable to trustees.

There are many cases in which the judgment of trustees has been challenged, and trustees may have good reasons for their actions, and attempt to defend themselves in court.  These kind of situations are easily distinguishable from recent reports of out-and-out theft and misappropriation of funds, as well as entrusting funds to investment advisors who offer no explanation of their activities over periods of many years.  But there seems to be a common thread linking many of these trust problems.

That link seems to be, generally, a lack of professional trusteeship.  In recent years, people have moved away, in many cases, from the idea of having a bank or trust company as a trustee or co-trustee, often because they charge fees for their services.  If Uncle Charlie will serve as trustee at no charge, then why is it necessary to have an independent trustee?  Perhaps now we have an answer to that suggestion: we’d better be very sure that Uncle Charlie has the skill and understanding to serve as a trustee.  Many Uncle Charlies will be fully capable of serving as trustee, but it might be appropriate to have some independent party, like a bank or trust company, to offer guidance and judgment in the administration of trusts.  That won’t be a guarantee against problems such as the criminal activities reported recently, but it can add to trust administration an unbiased and professional perspective.  This won’t always be necessary, but it’s something to consider in trust planning.

(Reprinted by permission of the Legal Intelligencer)

The world of estates litigation is certainly not boring. Sometimes it’s even about the money.

There are psychologists who provide a valuable service in trying to help families work through issues relating to inheritances. These kinds of issues often bring to the fore other issues that have been simmering for a while: why was one child chosen to be in the family business and another not; why one child got other advantages over a period of a lifetime; did one child plot to get on the good side of a parent to do better in the will?

It’s probably not possible to prevent intra-family disputes, and it’s not the lawyer’s task to become a substitute parent. It seems clear, however, that some of these problems are preventable. The prevention that can avoid them must be undertaken by the parents while they are still here. Sometimes that’s difficult to accomplish, because parents do not always want to share with their children their reasons for decisions made regarding the children and business interests. In addition, some parents are simply reluctant to discuss finances with their children. They may find it easier to say nothing and hope the children work things out. Like Scarlett O’Hara, they prefer to think about these things tomorrow.

As a number of commentators have suggested, it’s much better to discuss these issues openly, while the parents are able to explain the choices they have made. It’s probably also advisable to tell children how much they have and what their plans are for spending, saving and passing it on. It’s not easy to do that, and many parents will have kept their finances mostly secret from their children. But in many cases the result is the opposite of what the parents intended: money doesn’t make people happy or comfortable; it makes them crazy. So lawyers advising the parents would be well-advised to suggest disclosure to the children. The reaction might cause the parents to change their plans, perhaps in a way that attempts to head off trouble. In some situations, a family conference might be appropriate, and maybe such conferences should be held more than once. If talking through the problems or concerns among the family members doesn’t work, it might be time to call in a professional counselor.

As some philosopher, or at least a smart guy, said, not having money can make you miserable, but the opposite isn’t necessarily so: a lot of money won’t guarantee happiness. But at least talking it through can avoid some family disputes that end up in court.

(reprinted by permission of the Legal Intelligencer)

The alternative minimum tax, which grew from an effort to provide some level of taxation on those who used various tax-avoidance techniques into a monster that threatens to swallow the entire federal income tax system, is the subject of tax relief in the recently-signed stimulus legislation. The exemption from AMT is scheduled to fall each year and engulf many millions of taxpayers, unless a “patch” is applied. The patch temporarily increases the exemption, and is reenacted every year. In the stimulus legislation, the patch was increased to the following levels:

• Single and head of household  $46,700
• Married filing jointly  $70,950
• Married filing separately  $35,475

The rates remain the same: 26% on the first $175,000 of AMT taxable income ($87,500 if married filing separately), and 28% on the balance.

Here is a guest article on valuation from Chuck Bertsch, a well-known valuation expert who has helped many of our clients:

RE: VALUATIONS IN HARD TIMES

We often use the capitalized earnings method to arrive at the value of a business. This consists of selecting an earnings level representative of future expectations for a company and, then, capitalizing these earnings with a rate which reflects investor return requirements and long-term growth expectations [A capitalization rate is the same as a price to earnings ratio expressed as a decimal; e.g., a P/E ratio of 6 is equal to a capitalization rate of .167].

The capitalization rate is the company’s weighted average cost of capital (“WACC”). If a business is appropriately capitalized with all equity the capitalization rate, or WACC, is determined by reference to Ibbotson (now Morningstar) long-term equity returns, plus an allowance for specific risk. Alternative approaches exist.

Some companies, of course, can be financed with a mix of debt and equity. In these cases, a judgment is made as to the appropriate mix of capital inputs. A WACC which reflects the returns demanded by suppliers of both types of capital is then computed.

Suppose, for example, we have a company with $15 million of equity capital, no debt, and $3 million of net income. Using the Ibbotson procedure, we might come up with an equity return requirement of 20%. The $3 million of net income, capitalized with a rate of .20, yields $15 million as the value of the company.

If, however, we were to judge the company could be financed 40% with debt yielding 7% the calculation would be different. In this case we would compute a WACC of .148 (60% equity at a rate of .20, plus 40% debt at a rate of .07). The $3 million of net income, capitalized with a rate of .148, yields $20.3 million as the value of the company, a 35% increase from the all equity case.

Two years ago, or perhaps only six months ago, an assumption of 40% debt financing in a company’s capital structure might have been unremarkable. Today this is far less likely to be true. As we read on a daily basis, credit markets are closed to many borrowers or prohibitive in terms of cost (junk bonds have been priced to yield 18% to 20% in recent months). If we conclude that the company in our example can best be financed with only 20% debt (at rates higher than 7%), or no debt, the effect on WACC and value is obvious.

In the second paragraph above, we mentioned “specific risk.” In our view, specific risk premiums have escalated significantly over the last six months. This is partly because historical long-term rates of return do not reflect requirements in today’s exceedingly risk-averse environment; it also is because the vast majority of businesses confront much greater volatility in their earnings prospects (and, hence, more risk) than has been the case in past times.

The impact of these two factors, changes in WACC’s and specific risk premiums, mean that over the last six months most companies have suffered material declines in value even in cases where earnings have resisted the general downtrend.

Frederick C. “Chuck” Bertsch III, MBA, ASA

F.C. Bertsch & Co., Inc.

416 Roundhill

St. Davids, PA 19087

610-964-1800
610-964-1801 (fax)

fcb@fcbertsch.com

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F.C. Bertsch & Co.’s valuation practice focuses on ownership interests in closely-held businesses, partnerships, and limited liability companies. Chuck Bertsch has been valuing business interests for 30 years. He belongs to the American Society of Appraisers (where he is an Accredited Senior Appraiser) and the Philadelphia, Delaware County and Chester County Estate Planning Councils. He has served as CFO of two companies (one NYSE listed) and is a graduate of Wharton (MBA in Finance) and Wesleyan University

The U.S. Senate has just passed a cloture motion, which means that the stimulus bill will continue to advance to likely Senate passage, followed by negotiations with the House and an eventual compromise bill. The new legislation will contain a number of tax-cutting provisions. As soon as we know what the final provisions will be, another article will be posted on this website to explain the changes.

The bad news of our economic downturn has created good news in estate planning. Clients often ask us for help in transferring wealth to children and grandchildren, as a way of minimizing future tax liabilities. There are many ways of doing this, but they all have limits on the value of what can be transferred free of tax. Our current economic problems will come to an end and, as difficult as it may be to believe, we’ll be back in the plus column very soon. But, meanwhile, now is a great time to transfer assets, when values are temporarily reduced. It’s a good idea to have your estate plan reviewed periodically, and now is a very good time to do that, when tax-saving opportunities are more valuable.
In addition, several changes have taken place in the law applicable to estate planning, and they have created some further opportunities for effective planning at this time.
1. The annual federal gift tax exclusion has risen from $12,000 to $13,000 per donee. Annual exclusion gifts permit donors to transfer wealth to family members and others every year. At today’s lower values, more can be passed on to the next generation.
2. The federal estate tax exemption has risen from $2,000,000 to $3,500,000. This is a very large increase and permits families to transfer, potentially, up to $7,000,000 of assets without estate tax liability. It may permit less complexity in some estate plans. It is important to keep in mind that getting the maximum benefit from the estate tax exemption for husband and wife may require some shifting of assets or techniques to ensure that both husband and wife can use the estate tax exemptions. But this is the largest increase in the federal estate tax exemption in history.
3. This change in the estate tax exemption is effective throughout 2009. Under the structure of estate tax law now in effect, there is no federal estate tax with respect to persons who die in 2010, while in 2011, the tax returns with a much lower exemption, $1,000,000 and a much higher maximum tax rate, 55%. It seems very unlikely that this sequence of tax changes will occur. There has been a proposal made, which is supported by the new administration in Washington, to continue the $3,500,000 exemption indefinitely, with a maximum tax rate of 45%. Given the precarious budget situation in Washington, any further reduction of estate tax rates or increase in exemption seems unlikely. So, we can expect to have a federal estate tax, and it makes sense to plan and take steps now to reduce potential estate tax liabilities.
4. The interest rate used by the IRS for determining the amount of the gift that is made for certain types of planning techniques has reached an all-time low. The percentage rate for February 2009 is 2.0%. What does this mean?
• Grantor retained annuity trusts (GRATs) are particularly effective right now, because the amount of the gift will be low. GRATs are a method of deferred gift-giving, and they permit larger amounts to be transferred to the next generation.

• The same is true for charitable lead annuity trusts (CLATs) , but the lower IRS rate makes charitable remainder annuity trusts less advantageous. These are techniques to make combination transfers to charities and family members.

• Qualified personal residence trusts, which are deferred gift techniques for a residence, could be a great idea in an era of greatly reduced real estate values.

• Intrafamily loans or loans to controlled entities, can now be made (or restructured) at very low interest rates, another way of transferring wealth.

5. The requirement that persons who have reached age 70½ must take a minimum distribution from retirement savings has been suspended for 2009, for most types of qualified retirement plans and IRAs.
6. There is once again an opportunity for individuals who have reached age 70½ to roll over a portion of their IRAs, up to $100,000 per year, directly to charities. This technique offers significant advantages over the method of withdrawing funds from the IRA and paying them to the charity.

Please contact us if you would like to discuss any of these issues, or other estate planning matters.

In the midst of disturbing news about the economy, there are opportunities now available that make succession planning for businesses work well. There are two reasons: lower values for businesses and historically low IRS interest rates used in planning for wealth transfers.

It’s no secret that the economic downturn has reduced the value of many businesses. For those businesses that are well-run, it’s likely that this will be only a temporary drop, and that as the economy recovers, values should increase again. That means that this is a good time to transfer assets at the lowest gift tax cost.

In addition, the interest rates used by the IRS in determining the value of split-interest and deferred gifts is now at its lowest point ever, 2.0% for gifts made in February 2009. If a gift is made in the form of a grantor retained annuity trust, which allows a business owner to transfer ownership but defer the date when the transfer is completed, more can be transferred when the IRS rates are lower.

Succession planning is a complicated process, but the benefits of doing it correctly and at the right time are great. Now is the time to think about that kind of planning.

Unless you’re Charles Dickens, or one of the people involved in recently revealed alleged embezzlements that seem incredible.

My investment adviser suggested, or perhaps prayed, that the revelation of spectacular wrongdoing was a sign that we are coming to the bottom of the investment cycle. It’s not unlike the comment by someone, I think Warren Buffett, that when the tide goes out, you see who’s swimming naked. As always, there’s a lesson here, and it applies to everyone who has responsibility, however slight, for the care and management of money and other assets.

The lesson, fairly obvious, is that you must know where everything is, what’s being done with it and what people are charging against it. The rules of fiduciary responsibility are related in exhaustive detail in Austin Wakeman Scott’s treatise, in the Restatement of the Law of Trusts, in the Employee Retirement Income Security Act of 1974, and in numerous state laws and cases in Pennsylvania. We will shortly see the filing of many cases against Bernie Madoff and Marc Dreier, in which these principles will be cited. Between human greed, and Congress, lawyers will never go hungry.

Putting aside these spectacular examples of possible wrongdoing, the duty of care extends to many financial matters. Several of my clients have pension plans, where a third-party adviser handles investments. I am not the trustee and have no responsibility for the plans’ investments. Statements for the plans are sent to me monthly or quarterly. What is my responsibility with respect to those statements? I’m not to second-guess the investments, but perhaps there is at least a responsibility to make a cursory review of the statements. Either that, or I should either stop the statements from coming to me or advise the client that I cannot conduct any helpful review of the statements.

Here’s another example: A client has a retirement plan for which the investments are managed by one entity and the administration by another. Given the involvement of these two groups of experts, the client suggests that its office really need do nothing and has been able to supply few of the documents that it should have on hand. There’s probably nothing happening to cause concern, but I have advised the client that its responsibility is to have copies of all relevant documents, financial reports, and contracts setting forth who gets paid what for doing what. You can’t be criticized for having too much documentation of financial assets, but you can look like a great fool if you have to tell a judge, “I thought someone else was taking care of that,” or “They seemed honest.”

It’s not very likely that we will be involved in alleged embezzlements of the types reported recently, or the New Era scandal of a few years ago, or that we will meet up with the modern version Augustus Melmotte. But we will experience the need to be responsible in advising our clients on keeping good and careful records on the management of money and other assets, and this will help them from reading about themselves in newspapers or case reports.

REPRINTED WITH PERMISSION OF THE LEGAL INTELLIGENCER

Which is far better than lemonade. Here are some things that are likely to happen soon.

The new administration is still more than a month away, but there are definite ideas about what might be proposed and implemented next year. Some of those changes involve estate-planning issues. Legislation that is proposed some time next year can be made retroactively effective to Jan. 1, 2009. It seems likely that there will be legislation to fix the estate tax craziness that was enacted in 2001 ($3.5 million exemption in 2009, no tax in 2010, $1 million emption in 2011). One method of fixing the problem is to continue the tax in effect permanently at the current flat rate of 45 percent, with an exemption of $3.5 million, the 2009 amount. The problem with that solution is that it brings in a lot less revenue than the $2 million exemption in effect this year. An alternative is to leave the exemption amount at $2 million until our budget deficits fall below a trillion.

In addition to changing the estate tax exemption or the rate of tax, or both, it’s possible to affect the tax collected by changing the law on what’s included in the taxable estate. One of the largest increases in the estate tax base took place during the Reagan administration, when retirement benefits were subjected to estate tax. Some suggestions are now being heard in Washington, ideas that have been percolating for a while and that address someone’s notion of tax fairness.

One proposal that has been discussed relates to transfers of family limited partnership interests. Because these kinds of assets are not publicly traded, a practice has developed of discounting the underlying value of the partnership assets when a transfer, such as a gift, takes place. Percentage discounts are a matter of opinion, and the IRS has been concerned that these discounts are not valid in every case. We are likely to see a proposal to end these kinds of discounts, especially where the partnership assets are investment assets, as compared to an operating business.

Another technique that has been extremely popular for many years is making gifts by taking advantage of the unfortunately named Crummey powers (Crummey refers to the name of a successful litigant against the IRS). Crummey withdrawal rights, which are almost never exercised, permit gifts that are not outright transfers to come within the gift tax annual exclusion ($12,000 this year, $13,000 next year). The IRS has never liked this concept, and may use the circumstance of the large budget deficits to propose its discontinuance.

Other suggestions made include cutting back on other discounted gift techniques, such as grantor retained annuity trusts and qualified personal residence trusts. It’s possible to maintain the fiction that you haven’t raised taxes by cutting back or eliminating these techniques, since they don’t change tax rates. Many practitioners are trying to close as many transfer transactions as possible this year, to avoid greater restrictions that could affect the ability to do estate planning next year. We’re entering a time of change, and those practitioners who are knowledgeable on the opportunities created by that change will prosper in the next four years.

REPRINTED WITH PERMISSION OF THE LEGAL INTELLIGENCER