Tax-Management Techniques for Wealth Preservation


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U.S. Supreme Court Justice Oliver Wendell Holmes Jr. once famously remarked that “Taxes are what we pay for civilized society.” A century later, Americans are picking up the tab
to keep the government true to its task.

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Tax-Management Techniques for Wealth Preservation

  1. 1. Summer 2007 Insights for Preferred Clients U.S. Supreme Court Justice Oliver Planning in a Time of Uncertainty Tax-Management Wendell Holmes Jr. once famously While political realities may portend a Techniques for Wealth remarked that “Taxes are what we pay for civilized society.” A century murky future, a number of strategies are still available to help reduce income taxes Preservation later, Americans are picking up the tab for the next few years. You may even to keep the government true to its task. want to take some steps as you prepare to transfer wealth efficiently to your heirs While tax payments are Even after two major tax-rate reductions or to philanthropic causes. inevitable, several strategies during President George W. Bush’s first may at least minimize the term, the highest-earning one percent of Julia Chu of Advanced Wealth Strategies, taxpayers (i.e., those earning at least UBS Wealth Management, and a co- impact. $328,049 annually) paid nearly 37% of author of this article, has stated: all federal income taxes in 2004. Those in “Effective wealth management entails the top 10% (with incomes of at least minimizing income tax on key sources of $99,112 annually) shouldered 68% of wealth, including your compensation and the total tax burden, according to the investment portfolio, and also taking into U.S. Treasury Department. account state tax considerations.” So it should come as no surprise that Tax Management of Executive taxes present one important factor Compensation when attempting to maximize wealth Beyond cash, executive compensation and ultimately pass it on to the next often includes stock options and generation. While complete elimination restricted stock, both of which require of the tax toll typically cannot be meticulous planning to minimize their accomplished, several strategies may taxation. at least minimize the impact on a wealth management plan. • Stock Options An employee stock option is a right According to Patrick Luby, Executive granted by the company to an Director at UBS Wealth Management, employee to acquire stock at a “The ability to interpret the new tax laws specified price over a stated period of and build tax-efficiency into your overall time. If the stock appreciates in value, wealth and estate planning is absolutely the employee can exercise the option critical for optimizing long-term results.” and buy the stock at a bargain price. During the past few years, important There are two common types of stock changes have emerged from Washington, options: incentive stock options (ISOs) setting into motion a series of tax-rate and nonqualified stock options. An reductions and eliminations that are ISO is an option that meets special scheduled to last until the end of this requirements. A nonqualified option decade. But the future of many of these is any other option. The first major new tax provisions has become unclear. difference between an ISO and a abc
  2. 2. Summer 2007 nonqualified stock option concerns the event of exercising both types your assets, how you hold them and the time when the employee is taxed of options in the same year, over a how to approach a taxable sale. and the rate of tax. The employee is number of years,” says Chu. taxed on the date of exercise of a • Taxable versus Tax-Advantaged nonqualified stock option. • Restricted Stock Accounts Companies that issue stock to Allocating your investments between The employee must pay ordinary employees sometimes impose taxable and tax-advantaged accounts income taxes on the difference restrictions on the stock. There are such as an IRA or a 401(k) plan may between the fair market value of the many different types of restrictions. save taxes. Because investment stock on the date of exercise and the Some common restrictions include a income from bonds and other interest- option exercise price. The “spread” is prohibition on sale for a specified producing investments are taxed at subject to income, FICA and FUTA number of years; a right of first refusal your marginal rate (up to 35% on the withholding taxes at that time. The to purchase the stock; forfeiture if the federal level), tax-advantaged accounts employee recognizes short-term or employee terminates employment may be a better place to hold these long-term capital gain or loss on any before completing a specified length types of investments. subsequent appreciation or of service; and a requirement that the depreciation in the shares when the employee sell the stock back to the Long-term investments that produce employee sells the shares. By contrast, company at book value, fair market significant long-term capital gains (i.e., an ISO is not subject to ordinary value, a multiple of earnings, or some those that are taxed at a maximum income tax on the date of grant or other price. The employee may be federal 15% rate) may be a better fit exercise. However, the spread on entitled to vote the shares and receive for taxable accounts provided that exercise is a tax preference item, and dividends during the restriction period. long-term gains are taxed below your is subject to the alternative minimum The stock is usually issued to key marginal rate. Otherwise, in a 401(k) tax on the date of exercise. The employees as a form of incentive or an IRA, your capital gains would be employee is taxed at the long-term compensation. treated as ordinary income when it’s capital gains rate when the employee distributed. Investors should also pay sells the shares if two holding periods For stock transferred as compensation, close attention to seeking out are met. generally the employee is taxed when “qualified dividends” to take the stock is first either transferable or advantage of the 15% rate in their First, the sale must be made at least not subject to a substantial risk of taxable accounts. Consult with your two years after the date of grant. forfeiture. The amount of taxable Financial Advisor to ensure that your Second, the sale must be made at income is the fair market value of the dividends are qualified. least one year after the date of stock, less any amount that the exercise. The amount of capital gain is employee pays for the stock. “It really comes down to making equal to the difference between the assumptions about what your tax rate sale price and the option exercise “As a result, restricted stock also calls will be in the future and whether you price. If you meet the required holding for the careful planning for the think those will be lower than the periods, you may benefit from an corresponding income taxation,” says capital gains rate you would be paying ISO as a result of the lower capital Chu. “As with any substantial increase if you held those investments in a gains rate. Otherwise, where the ISO in ordinary income, you may also taxable account,” says Luby. holding periods are not met, the gain consider with your tax advisor how is ordinary (wage) income up to the charitable planning may align with • Offsetting Gains with Losses FMV at the date of exercise, the same your personal and financial goals in You may consider reducing your capital as a non-qualified. Any gain (or loss) reducing your overall tax liability.” gains by selling losing positions to offset beyond that to the date of sale is some or all of your winners. By realizing capital gain or loss. Tax Management of Investment a loss, your reported investment gains Portfolio and tax liability decrease. Some The differing tax treatment of Effective tax management occurs beyond investors wait until year-end to harvest nonqualified stock options and year-end portfolio adjustments and losing positions, but you may do so on ISOs—including the holding period includes regular review and judicious an ongoing basis throughout the year. If rules and alternative minimum tax asset allocation. Some fundamental you have held a profitable position for considerations—requires careful questions to consider for optimizing less than one year, match its sale with a timing and execution, especially in after-tax return include: the nature of short-term loss. 2
  3. 3. Summer 2007 Be aware that the “wash sale” rule funds make capital gains distributions name, the marital deduction merely requires a 30-day waiting period late in the year, resulting in tax liabilities postpones the payment of tax, because before buying back any stock or for all fund-holders—regardless of property that qualifies for the marital security that you’ve sold at a loss, if whether they have held shares all year deduction in the estate of the first you wish to claim it for tax purposes or bought them just a week before the spouse to die is includable in the estate in that year. There is also a 30-day distribution. You might want to check of the surviving spouse, unless before the sale prohibited purchase the fund’s prospectus to find out when dissipated by the surviving spouse period. As a result, the “wash sale” distributions are made and maybe buy during his or her lifetime. rule effectively defers the recognition after that date. of loss on the sale of a security where The most direct way to obtain the marital the purchase of a substantially Wealth Transfer: Estate and Gift Tax deduction is for an individual to simply identical security is made within the Tax planning remains a lifelong endeavor bequeath property directly to his or her period 30 days before and 30 days that continues through estate planning spouse. Sometimes, however, you may after the date of sale at a loss. and poses additional challenges in light wish to place restrictions on the bequest, of tax rates and exemptions over the or have the property managed by a • Tax-Advantaged Investments next few years. For 2007 and 2008, professional manager. In these cases, Consider tax-advantaged investments, taxable estates in excess of the $2 million certain kinds of trusts such as qualified such as municipal bonds on the fixed- applicable exclusion amount are subject terminable interest property (QTIP) trusts income side of your taxable portfolio. to as much as a 45% tax. This threshold and power of appointment trusts can Interest on municipal bonds is free rises to $3.5 million in 2009, and the be used. from federal income tax and, federal estate tax temporarily disappears depending on your state of residence in 2010. In 2011, barring further • Educational or Medical Expenses and the issuer of the bond, may also Congressional action, the tax is An unlimited exclusion from gift tax be free from state or local income scheduled to return with an exclusion of is available for amounts paid on taxes. With municipal bonds, the key just $1 million and a top estate and gift behalf of an individual for medical consideration is your “tax-equivalent tax rate of 55% and a 5% surtax on payments or for tuition paid to an yield,” which is the equivalent pretax certain transfers of over $10 million. educational institution. The payments yield on a taxable bond, given a excluded must be paid directly to the holder’s particular applicable tax rates The generation-skipping transfer (GST) medical care provider or educational that would yield the same as a specific tax is an addition to any gift or estate institution. “Only direct tuition costs tax-free investment. tax payable and arises upon any transfer are covered by the educational expense to a person more than one generation exclusion,” Chu notes. Amounts You must also consider the issuer’s below the transferor’s generation. spent for books, supplies, room and credit quality and the bond’s maturity The generation-skipping transfer tax board or other similar items do not to make accurate comparisons. exemption amount in any calendar year constitute qualifying tuition costs. A Municipal bonds may be especially is the same as the applicable exclusion corresponding educational and medical attractive for taxpayers who live in a amount for federal estate taxes, and exclusion enables grandparents to high-state-tax jurisdiction. “It is critical the GST tax is a flat-rate tax equal to provide for the benefit of their to incorporate state tax considerations the maximum estate tax rate. grandchildren without incurring in your fixed-income planning, as state generation-skipping transfer tax. and local taxes may significantly “The judicious use of certain strategies impact your overall after-tax return,” may help you maximize the transfer of • Gifting says Chu. “State tax issues may also wealth and minimize the tax impact for The applicable exclusion amount arise upon migrating from one state your estate and beneficiaries,” says Chu. reflects the amount of assets that you to another.” may transfer free of estate and gift • Marital Deduction taxes. As stated above, the applicable • Pay Attention to Timing For estate and gift taxes, transfers exclusion amount for estate (but not The 15% long-term capital gains tax between spouses generally qualify for gift) tax purposes will increase to rate only applies to a security that you an unlimited deduction (the marital $3.5 million by 2009, while the hold for over a year, so be sure to deduction), resulting in no tax with lifetime gift tax applicable exclusion watch the holding periods. In addition, respect to the transfer. Accordingly, you amount remains fixed at $1 million. proper timing of purchases and sales of may transfer unlimited amounts to your “The applicable exclusion amount mutual funds in taxable accounts may spouse either during life or at death applies first to lifetime taxable gifts produce substantial tax savings. Most free of wealth transfer taxes. Despite its as they are made, with any unused 3
  4. 4. Summer 2007 portion applied against the decedent’s “wealth replacement” trusts may hold property, which can be sold by the taxable estate,” says Chu. a death benefit policy on your life and trust tax-free, with capital gains tax pay proceeds tax-free to heirs. Since potentially deferred for the You may utilize the $1 million amount trusts often serve as an effective beneficiary. against direct transfers, or transfers vehicle for utilizing your applicable made to a trust designated with exclusion amount and annual • Charitable Lead Trust (CLT) various names: credit shelter trust; exclusion, it is critical to examine the A CLT (a taxable entity, unlike a bypass trust; or a family trust. Through full array of existing and potential CRT) also removes assets and further credit shelter trusts, an amount of trusts in your overall estate plan. appreciation from your taxable estate. property equal to your remaining Payments work in the reverse order, applicable exclusion amount ultimately “Both the applicable exclusion amount with the charitable organization passes to the next generation, without and annual exclusions constitute receiving income during the term being subsequently included in the valuable but limited tools and thereby of the trust and your heirs receiving gross estate of your surviving spouse. warrant careful utilization to optimize the assets plus appreciation free their impact to you and your family,” from additional estate taxes at the “Careful titling of assets remains says Chu. “In addition, choosing an end of the term. This strategy has gift necessary to ensure the full utilization experienced and impartial trustee also tax consequences and may entail of both spouses’ applicable exclusion remains critical for protecting your using part or all of your applicable amounts,” says Chu. In addition, you wealth across generations.” exclusion amount. may gift $12,000 (in 2007) per year to anyone, without restriction on the • Charitable Giving • Private Foundation number of beneficiaries. For gifts There are three primary recipients of These are ideal for large estates and made to a trust, the beneficiary must your estate: your heirs, charity and for families that are passionate about have certain rights for this annual the government. Through effective making regular gifts, and wish to exclusion to apply. You may also estate planning, you may determine actively engage in the governance and effectively transfer five times the beneficiaries and amounts. “Gifting to legacy of a separate charitable entity. annual exclusion amount in one year a charitable organization may advance Foundations may be costly to run to a Section 529 plan. “However, your philanthropic values and may also and must disburse 5% of assets before utilizing any one strategy, it is produce both income and transfer tax annually to nonprofit organizations. important to review all applicable advantages,” says Chu. The As a tax-exempt entity, a private vehicles for optimal transfer tax corresponding income tax deduction foundation may receive and sell savings,” adds Chu. of any charitable gift depends on its publicly traded appreciated property structure and remains subject to without incurring capital gains tax. If you and your spouse consent to split percentage limitations based on your your gifts, you may treat the gift as adjusted gross income. • Donor-Advised Fund one-half by each spouse, enabling you The donor makes a contribution to both to utilize each of your annual – Outright Gifts: Direct charitable gifts a domestic public charity, which exclusion and applicable exclusion reduce your estate and directly fund manages the fund and receives and amount. the charity of your choice. considers recommendations made by the donor regarding distributions from • Irrevocable Trusts – Charitable Remainder Trust (CRT): the fund. Through this vehicle, the Establishing irrevocable trusts may This is a common vehicle that donor is relieved of administrative yield numerous estate-tax savings effectively removes assets from your burdens, including the preparation and opportunities and help to preserve estate and produces an income tax filing of tax and informational returns. wealth for subsequent generations. deduction. During your lifetime you As with private foundations, donor- Although initial gifts may be subject may receive a stream of income advised funds may receive and sell to gift tax, further appreciation will (subject to income tax) from the publicly traded appreciated property take place outside of your estate. trust, and at the end of the term without incurring capital gains tax. So-called “dynasty” or “legacy” the remaining assets pass to a trusts may hold assets for multiple charitable organization of your In light of the Pension Protection Act generations to come, although an choosing. The CRT is a tax-exempt of 2006 and the Treasury’s ongoing additional generation-skipping transfer entity, making it particularly suitable study, planners should urge their tax may apply. Life insurance or for transferring appreciated clients to consult with their legal and 4
  5. 5. Summer 2007 tax advisors before contributing to a Focus on Preservation donor-advised fund and ask the fund With tax laws in flux, income and estate- managers about what steps they have tax planning may be highly challenging. taken to comply with the new A comprehensive strategy may help you legislation. achieve the results you need today and well into the future. About the Contributors Patrick Luby, Executive Director Julia previously was a lead tax strategist for the Private Head, Product Strategy, Transaction Products Client Group of Prudential Securities. Before that, Julia Patrick Luby is Head of Product Strategy for UBS’ served as planned giving counsel for the State University Transaction Products area. Patrick has been with of New York and lead grant writer for New York University UBS Financial Services Inc. for over 15 years and in School of Law. She has also practiced at Muchnick Golieb the financial services industry for 24 years. He has & Golieb, a boutique New York law firm specializing in more than 20 years of municipal bond-related tax law. experience. After obtaining her B.A. at Cornell University and J.D. at Julia Chu, Director, Trust and Estates Specialist, Boston University, Julia received her Tax LL.M. degree Advanced Wealth Strategies at New York University School of Law. Julia Chu initially joined UBS as a Trust and Estates Specialist, where she directly supported UBS Private Planning through document review, collateral research and client meetings. Thereafter, she built the philanthropy consulting platform of UBS Trust Co., N.A., for private foundations, providing guidance on the organizational infrastructure, overall grant strategy and investment management needs.
  6. 6. Summer 2007 ©2007 UBS Financial Services Inc. All Rights Reserved. Member SIPC. All other trademarks, registered trademarks, service marks and registered service marks are of their respective companies. This article contains general discussions of certain legal and tax concepts for the subject matter covered. UBS Financial Services Inc. does not provide tax, legal or accounting advice. Please contact your tax advisor regarding the suitability of tax-exempt investments in your portfolio and your accounting advisor to determine the appropriate accounting treatment. While we do not provide tax, legal or accounting advice, we can confer with your advisors to help them understand the investment implications of different securities and investment strategies. Income from municipal bonds may be subject to state and local taxes as well as the Alternative Minimum Tax. Call features may exist that can impact yield. If sold prior to maturity, investments in municipal securities are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. As a firm providing wealth management services to clients in the U.S., we offer both investment advisory programs and brokerage accounts. Advisory services and brokerage services are separate and distinct, differ in material ways and are governed by different laws and separate contracts. For more information, please visit our website at We make financial planning services available to you in our capacity as an investment adviser. The financial planning engagement terminates when the plan is delivered to you. It is important to note that the financial planning engagement does not alter or modify in any way the nature of your UBS accounts, your rights and our obligations relating to these accounts or the terms and conditions of any UBS account agreement in effect during or after the financial planning service. Should you decide to implement any aspect of your financial plan with us, we will act as either a broker-dealer or an investment adviser, depending on the investment product or service that you select. For more information on the distinctions between our brokerage and investment advisory services, please speak with your Financial Advisor or visit our website at Wealth Management services in the United States are provided by UBS Financial Services Inc., a registered broker/dealer offering securities, trading, brokerage and related products and services. Neither UBS Financial Services Inc. nor its employees (including its Financial Advisors) provide tax or legal advice. You should consult with your legal counsel and/or your accountant or tax professional regarding the legal or tax implications of a particular suggestion, strategy or investment, including any estate-planning strategies, before you invest or implement. UBS Financial Services Inc. 070627-2209-V147 UBS Financial Services Inc. is a subsidiary of UBS AG.