5 Ways to Secure Wealth in a Downturn

Although economic downturns, such as the one we are currently experiencing, can have real hardships for many people–there are silver linings for those fortunate to take advantage of them. Reduced values combined with lower interest rates create five (among other) key ways that families can gain advantages in dark economic times.

  1. Sell the Family Business to Lower Generations

It may sound counter-intuitive, but selling the family business in a downturn can be the best way to move wealth to the next generation and create a stream of income for the selling owner. When an owner wants to sell to family, one common hurdle is the ability of the company and family to afford to finance the asking price. However, if the business is suffering due to the economy, then a suppressed valuation can make the cost of supporting a seller financed deal more manageable. Additionally, with low interest rates (as low as 0.99% in April 2020), the lower generation and the business can be better able to cover the financing charges while not risking the viability of the company.

When this is done at fair market value, the transaction is not a taxable gift. Additionally, if the sale is made to a “grantor” trust of which the selling owner is the “grantor,” the transfer can be accomplish income tax free (see Rev. Rul. 85-13). Such a trust could also be structured to protect the lower generation owners from their creditor claims, further securing the family wealth in the future.

2. Make Gifts of Depressed Assets

Similar to the sale option above, an outright gift can have great advantages in a bad economy. Even liquid assets, such as stocks and bonds, are at reduced valuations, which means gifts can be made of many assets that have a discounted value (relative to their historic values). When the assets return to their historical values and growth after the gift, the future growth will sit in the hands of lower generations, free of gift tax and out of the estate of the donor (assuming the donor does not retain certain powers over the gifted property). In “normal” times, such discounting is usually found in the form of difficult to value, unmarketable, and minority interests in companies–such as the discounts usually found in an appraisal of a minority interest in a family limited partnership. Now, the discounting even exists for easy to value property and without the need for an appraisal.

3. Make Low Interest Loans

If a donor does not have a business to sell, and does not want to give up liquid assets, then a middle ground would be to loan money to lower generations at the currently low interest rates. The lower generations, or trusts for their benefit, can then re-invest the loaned funds and may keep any increase in value over the principal and interest rate of the loan. If the note bears a long enough term, then the chances of even conservative investments outperforming the interest rate are good. The balance left over in the hands of the lower generations passes gift tax free. Again, if “grantor” trusts are the borrowers, the loan can even be structure as an income tax free transaction to the donor.

This technique can also be used to shift wealth between trusts. Some older trusts that were funded when generation-skipping transfer tax exemptions were low may have been split into “exempt” (meaning not subject to generation-skipping transfer tax) and “non-exempt” (meaning fully subject to generation-skipping transfer tax) trusts. In that case, a non-exempt trust can loan funds, at low interest rates, to an exempt trust and the exempt trust would retain the investment growth that exceeds the interest rate and principal of the note.

4. Make Roth Conversions

When investments take a dive along with income, there is an opportunity for taxpayers with taxable deferred accounts to convert those accounts into Roth accounts. This could be done for IRAs or 401k accounts (assuming the plan provides for Roth accounts). Although the balance that is converted into a Roth account is included in the account owner’s income in the year of the conversion, if the owner has suffered a reduction in income due to the economy the tax hit is mitigated, and the suppressed market values further reduce the tax hit, at least on historic levels. Roth accounts have two advantages: (1) they continue to receive income tax free growth (when the market corrects to historic growth); and (2) distributions can be income tax free if the account is held for at least 5 years before the distribution and (i) the owner is at least age 59½, or (ii) the distribution is due to the owner’s disability, or (iii) the distribution is paid after the owner dies.

5. Purge Passive Foreign Investment Companies (“PFICs”)

For people holding investments in foreign mutual funds (which are almost always PFICs), very penalizing “anti-deferral” rules ordinarily apply to a sale of those investments. The anti-deferral rules treat the gains as ordinary income and then impose an interest charge to the income tax as if it was underpaid tax spread over the duration the owner held the investment. While it is difficult to avoid this result after the owner has held a PFIC for several years, when markets drop in value there is an opportunity to either sell the PFIC or elect a deemed sale of the PFIC stock in order to cleanse the owner’s investment portfolio from a potentially much worse income tax hit if they hold the PFIC in the future when values rebound.

Taking these steps can allow the owner to reinvest in capital assets that are outside of the anti-deferral rules and that are subject to the currently much lower capital gains rates. The difference between the income tax rates plus the interest charge versus paying capital gains rates in the future can be sobering. Even ignoring the interest charge, the rate differential at the highest federal income tax rates is 17%. Thus, a down market opens an avenue to escape a massive tax hit in the future for a relatively cheap exit toll.

Leave a Reply