Asset Location Issues
Because that's where the money is.
—Willy Sutton, when asked why he robbed banks
“Asset location,” as its name implies, refers to the question of where to locate each of the investments expected to be employed in the overall portfolio. Unlike most institutional investors, private investors own their assets in many, many different forms. For example, it is not unusual to encounter, in one large family, assets held in the private accounts of different generations, in the private accounts of many different individuals, in the accounts of different collateral family units, in family investment partnerships and family limited partnerships, in charitable foundations, family trusts, IRAs, closely held corporations, LLCs, offshore vehicles, intentionally defective grantor trusts, dynasty trusts, and the alphabet soup of tax and charitable vehicles such as GRATs, GRUTs, CRATs, CLATs, CLUTs, CRUTs, NIMCRUTs, cascading GRATs, and so on. Each of these vehicles is typically created for a specific, largely noninvestment purpose, but each holds assets that must nonetheless be properly invested. The decision about which investments should go into which vehicles is mainly a tax-driven issue, but other issues will also be present and they will sometimes be decisive.
I could write an entire book just on the asset location issue, but in deference to my readers' patience I will only identify the issue as a crucial one and illustrate some of its complexities. Families will, in the main, have to rely on their legal, tax and investment advisors when to comes to asset location issues, but it is important at least to recognize the issue and understand its importance. The simple fact is that, all too often, the good work of our tax, trust, and estate planning advisors is undone by financial advisors who misunderstand the nature and taxability of complex vehicles.
Practice Tip
One very common set of asset locations is the family's personal fortune and the capital held in a family foundation. As an advisor, you might be thinking that to the extent the family's liquidity needs relate to charitable commitments, those could in fact be discharged by the foundation. But this is true only in limited circumstances.
If the family makes a charitable pledge and that pledge is fulfilled by the foundation, the directors or trustees have engaged in a self-dealing transaction and can be subjected to large fines. On the other hand, the family is free to discharge individually any pledges made by their foundation.
Thus, although these may seem like minor differences, they are crucial ones, and as an advisor to wealthy families you need to be aware of how the IRS views the world.
Examples of Asset Locations and the Associated Investment Implications
In the following paragraphs I give brief examples of estate planning vehicles that are frequently employed by families, along with some of the more obvious investment implications associated with using those vehicles. I want to emphasize that the vehicles are discussed merely as examples of the issues that tend to arise; they are by no means exhaustive.
Asset protection trusts (APTs). These offshore (and sometimes onshore) vehicles are often used by clients in litigious professions or who fear large legal judgments. They are similar to spendthrift trusts—indeed, they are in effect self-settled spendthrift trusts—except that the trust is established in a jurisdiction with laws that make it difficult for creditors to enforce their rights (often via very short statutes of limitation and very limited discovery rules). A key provision is the presence of a “protector” who will not be subject to U.S. court orders. Unlike true spendthrift trusts, in an APT the presence of the donor as a discretionary beneficiary does not render the gift to the trust incomplete. Hence, APTs can effectively be used to remove assets from the estate of the donor. APTs must be created before a judgment is entered against the donor, and preferably before any claim has been asserted or even arisen.
Investment implications: All U.S. taxes must be paid on income and gains as they occur, exactly as though the trust were a domestic trust. Consequently, the investment considerations will be similar to those posed by a domestic portfolio. Assets placed in APTs may remain in trust longer, and hence have a longer investment time horizon associated with them, than the same assets may have had when held directly and domestically. On the other hand, many investors who establish APTs see them as an ultimate “anchor to windward” and will wish to see the assets in the trust invested very cautiously.
Charitable lead annuity trusts (CLATs). A CLAT pays a fixed amount to charity for a period of years, then passes (outright or in trust) to the children or other beneficiaries tax-free. A charitable deduction is available for the expected present value of the charitable payments. A significant amount of property can be removed from the donor's estate at no tax cost using properly structured CLATs.
Investment implications: Investment implications tend to depend on the charitable intent of the donors. Donors may wish to benefit charity, in which case high-income assets will be placed in the trust. If they wish to benefit the children, on the other hand, low-income, high-growth assets will be placed in the trust. Note that the investment advisor may be representing the donors or the ultimate family beneficiaries, or, in some case s, both.
Charitable lead unitrusts (CLUTs). A CLUT is simply a CLAT that pays to charity a percentage of the fluctuating value of the trust assets, rather than a fixed amount.
Investment implications: Generally, same as a CLAT. However, the fluctuating value of the payments to charity must be taken into account—the use of very low-yielding assets in CLUTs is usually unwise.
Charitable remainder annuity trusts (CRATs). A CRAT is the opposite of a CLAT: Assets in a CRAT pay a fixed amount of income to the donor for life or a period of years, then pass outright to charity—which can be a family foundation. Appreciated property is usually placed in a CRAT. The donor receives a charitable deduction for the value of the gift less the value of the income payments. CRAT payments must equal at least 5 percent of the value of the property.
Investment implications: Most donors will want to ensure the annuity payout to themselves, and may have little interest in how much ultimately passes to charity. However, this is not always the case. Remember that taxes paid by the beneficiary are determined by the nature of the income at the trust level. Highest taxable income must be distributed first.
Charitable remainder unitrusts (CRUTs). A CRUT is a CRAT that pays the donor a percentage (not less than 5 percent) of the fluctuating value of the trust. The donor can make additional contributions to a CRUT, unlike a CRAT. Surprisingly, a CRUT can pay out the lesser of 5 percent or the net income of the trust, making it ideal for appreciating assets that pay little or no income.
Investment implications: CRUTs are generally used when there is a serious charitable motive. Remember that taxes paid by the beneficiary are determined by the nature of the income at the trust level. Highest taxable income must be distributed first.
Dynasty trusts. This is a term typically applied to any trust that is designed to last for several generations. Dynasty trusts created in states that have abolished the rule against perpetuities (e.g., Alaska, Delaware, Idaho, South Dakota, Wisconsin) can theoretically last forever, although the Internal Revenue Service has proposed sunsetting provisions.
Investment implications: These vehicles have very long investment time horizons and few income demands. Most donors will want to see the assets in a dynasty trust invested aggressively, consistent with fiduciary principles.
Generation-skipping trusts. Gifts that skip a generation are subject to a high flat tax, plus the usual estate tax. There is a (fluctuating1) lifetime exemption available to each spouse. The parents create a trust and allocate their GST exemptions to it. GST trusts are limited in most states by the Rule Against Perpetuities, but by creating the trust in a state that has repealed the rule (see above), the trust can theoretically last forever. A GST dynasty trust can be leveraged considerably by combining it with a CLUT.
Investment implications: These vehicles have very long investment time horizons and few income demands. Most donors will want to see the assets in a dynasty trust invested aggressively, consistent with fiduciary principles.
Grantor retained annuity trusts (GRATs). Under a GRAT, the grantor retains the right to receive a fixed dollar amount for a specified number of years. Assuming that the grantor survives the annuity period and that the assets in the trust appreciate rapidly, a considerable amount will pass to the children free of estate and gift taxes. A gift is made upon the creation of the GRAT equal to the initial value of the assets reduced by the value of the annuity payments. Investors can also create zero-gift GRATs by setting the annuity amount so high that no gift is made. Gifts of closely held stock and limited partnerships are especially useful because they are already discounted for lack of marketability. The grantor is taxed on gains in the trust, and these tax payments represent additional tax-free gifts. So-called “cascading GRATs” are often used in situations where it is possible that an investment will appreciate extremely rapidly. If so, a substantial sum is passed tax-free to the children. If not, the GRAT simply expires harmlessly (assuming the grantor survives).
Investment implications: Investments in GRATs should be as aggressive as is consistent with the need to make the annuity payments (or more aggressively in the case of cascading GRATs).
Insurance wraps. Placing a tax-inefficient asset inside an insurance product (usually a modified endowment contract or a variable annuity contract) causes the tax consequences to pass to the insurance company while the gains remain in the policy as increasing cash value. The insured can access the cash value through low-cost policy loans or simple cash withdrawals. Many insurance wraps are structured through offshore insurance companies to avoid strict state rules on investment options. The ongoing costs of these programs is an important issue, and the IRS is cracking down on perceived abuses.
Investment implications: These vehicles are useful to shelter the income from growth assets that generate substantial ordinary income or short-term capital gains; for example, nondirectional hedge funds. Keep in mind that the insured cannot select the investments inside the policy.
Intentionally defective trusts. An intentionally defective trust is one that will not be includable in the grantor's estate but on which the grantor pays all taxes, even though the income or appreciation is going to the children. These taxes represent an additional untaxed gift. A trust can be “defective” by giving the grantor the right to “sprinkle” income or principal among a group of beneficiaries, by retaining the power to reacquire the trust assets by substituting property of equal value, or by providing that the trust income can be distributed to the grantor's spouse.
Investment implications: Because the donor pays all taxes, his or her tax picture must be kept in mind. It is usually preferable to invest in assets that generate long-term capital gains.
NIMCRUTs. A version of a CRUT containing an income makeup provision that allows more income to be paid out in later years, to the extent that income paid out in earlier years was less than the required percentage amount. Thus, rapidly appreciating property can be placed in a NIMCRUT while the donor is young; later, during retirement, the investments can be switched to high-yield assets paying the donor a very high income.
Investment implications: Invest in high-growth, low-income assets during the accumulation phase, and high-income assets (e.g., junk bonds) during the payout phase.
Offshore trusts. Offshore trusts offer investors no tax benefits if the donors or beneficiaries are U.S. citizens, but many wealthy clients will have non-U.S. citizens somewhere in their families. This presents the opportunity to site trusts in offshore jurisdictions and avoid all U.S. (and often foreign) taxes.
Investment implications: These depend entirely on the needs of the beneficiaries.
Private foundations. Foundations can be established as trusts or corporations. Corporate foundations tend to be simpler to administer and they avoid bizarre state limits on investments. Trusts, however, are better equipped to preserve family control across the generations. A private foundation is a grant-making organization which must make grants and other payments (or in IRS terms, qualifying distributions) equal to 5 percent or more of its average assets each year; pays a 1 percent or 2 percent excise tax, depending on the scale of the grant-making; must file a Form 990-PF with the IRS every year; and must make available to the public either its 990-PF or an annual report. Note that most foundations will likely find themselves the target of unsolicited funding proposals, and failure to respond to these funding requests can harm the family's reputation. Gifts to private foundations are limited to 20 percent of adjusted gross income, rather than the 50 percent deduction permitted for gifts to public charities. For this reason, many “smaller” foundations are set up as donor-advised funds at a community foundation.
Investment implications: Fearful of not generating enough income to meet the payout requirement, many foundations invest far too conservatively. During extended bear markets (as in the 1970s and early 2000s), the 5 percent payout requirement, plus the excise tax, can actually amount to a much higher percentage of the current asset base. Even during normal market conditions, overly cautious investment strategies can result in investment returns that are well below those needed to grow the foundation's assets in real terms (payout requirement + excise tax + inflation).
Revocable trusts. Also called revocable inter vivos trusts. These are best viewed as property management vehicles. Revocable trusts have no tax benefits and, in most states, few other benefits (despite the claims of a few unscrupulous lawyers and accountants). Assets placed in a revocable trust must be retitled in the name of the trust, and if the trustee is anyone other than the grantor, separate tax returns must be filed. In certain states revocable trusts can avoid some of the costs of probate, and such trusts can also, for wealthy families, be useful for complex asset management situations (where a durable power of attorney might be too simple), and to preserve privacy. In a few states a revocable trust can be used to prevent a spouse from receiving his or her statutory share of the grantor's property at death.
Investment implications: The only investment issue is the important point that well-drafted revocable inter vivos trusts can be effective asset and property management vehicles with less unwieldiness than a general power of attorney, and therefore assets such as real estate will typically be placed in them.
There are a thousand and one other issues associated with the proper location of investment assets in complex family portfolios, but the point is that these issues need to be addressed with care and sensitivity. The most brilliantly conceived investment portfolio and estate plan can be seriously undermined by the failure to locate assets in the right locations.
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