As family offices evaluate their investments and assets during the economic downturn caused by the coronavirus pandemic, tax considerations will help them manage liquidity and estate planning.
Noah Ginsburg and Ben Berger, two RSM partners and members of the firm’s national family office team, recently discussed how the valuation of distressed assets can shape family offices’ strategies during the economic response and recovery stages. The following Q&A session has been edited for clarity.
For family offices, what are the most significant tax considerations regarding the valuation of their distressed assets and investments during the economic downturn?
What family offices are looking for is any change in the law that will allow them from a liquidity standpoint to go back and recoup taxes. The concept is: Where can we get deductions under the CARES Act that we weren’t able to get before? The three main opportunities are section 165(i)—financial loss due to natural disaster, excess business loss limitation and worthless stock.
For family offices with operating businesses, the disaster-area deduction, section 165(i), has to do with assets in which the businesses have been directly affected by COVID-19 and incurred costs because of it. The benefit under the CARES Act is you can elect to take these deductions in 2019 even though they happened in 2020—if you can satisfy the criteria to claim a loss under section 165(i).
What factors contribute to uncertainty about satisfying the section 165(i) criteria?
As a firm, we have issued some guidelines on the section 165(i) rules that discuss when this loss might apply. In general, you need to have physical damage or other costs that are directly attributable to COVID-19 and not reimbursed by insurance. Some examples of these are assets/inventories that are scrapped or abandoned, worthless securities and business locations that are closed. The harder part is determining whether you can take a decrease in goodwill as a permanent decrease in value, and you’ll never recoup that. It’s a business-by-business discussion. It’s not the easiest argument, and it’s got to be situation-by-situation and fact pattern-by-fact pattern. It’s the hardest one to claim. Three years from now, will the business rebound and the decrease in value turn out to be only temporary?
Someone might have a building that was worth $2 million before the pandemic, and now it’s worth $500,000. They believe they should be able to write off $1.5 million. That’s difficult because there’s no physical damage and no assets abandoned. Let’s use a mall as an example. If 70% of your tenants went bankrupt, and now you have no revenue, is that a permanent decrease or not? In three years, you could find new tenants, and it’s not permanent; it’s just temporary. That’s the gray area. There are a lot of speculations here, especially in the goodwill area. It has to be a permanent decrease in value, not a temporary decrease.
What other considerations apply to claim a loss under section 165(i)?
The umbrella concept is writing down assets. How do we write down assets? With distressed investments, we would either have to sell them for a very small amount to take the loss, or claim they’re worthless. You want to review all your assets and identify any stock investments or distressed assets that are not worthless that you’re abandoning to take the tax write-off.
Worthless is defined in the law. It has to have no value. So let’s say you owned assets in a company that went into bankruptcy. When that company comes out of bankruptcy, and it is determined that you will get nothing, it’s worthless at that time. If it’s a liquidating bankruptcy, and you’re not going to get any money, and the company sends you a letter saying, “Under our bankruptcy plan, you will not get any money,” then that would be a claim of worthlessness. You would write it off at that point. For worthlessness, you need proof that it’s worthless.
What about the excess business loss limitation, section 461(l)?
The CARES Act retroactively eliminated the excess business loss limitation for tax years 2018 and 2019. If you had a business loss in excess of business income, the loss was nondeductible. Any excess is a carry-over item. The law now allows for the loss deduction in 2018. For example, say an individual had a $400,000 excess business loss in 2018 that we were carrying over to 2019. Now, we can amend the return in 2018 to take the loss.
Some family offices have investments in qualified opportunity zones. How has the economic disruption affected them?
The general rules on qualified opportunity zones are if you buy a piece of property or invest in a property in a qualified opportunity zone, and you double the amount of investments in improving the asset, then depending on how long you hold the asset, you may be able to defer/exclude any gain. There were a lot of investments in QOZ property; however, you have to spend it within a certain amount of time. Depending on the structure, 90% of the assets have to be in qualified opportunity zone property (QOZP). Cash does not qualify as QOZP. This 90% rule gets tested twice during the year—June 30 and Dec. 31.
For example, let’s say you put in $200,000 on Jan. 1. You bought the property for $100,000, and now you have another $100,000 to improve it. If you don’t spend at least $80,000 by June 30, you will violate the 90% test. However, due to the pandemic, if the construction is held up, and you cannot spend the money in time, you end up getting penalized.
Recently, the rules have changed for 2020. The testing date for the 90% test was pushed back to Dec. 31, 2020. Therefore, as long as you meet the 90% test by Dec. 31, 2020, you will not have a penalty for 2020. Under the old rule, investors put in cash in December thinking they’re going to spend it by June, which was the original testing date, and suddenly construction got delayed. Now, they have too much cash, which means the penalty starts. People are reexamining their qualified opportunity zone investments and making sure that they’re still on track for the construction and improvements in order to keep the deferral. If you hold it 10 years, you get a permanent deferral. If you hold it five or seven, you get a haircut off the gain. Some families are looking at opportunity zone investing they did to make sure they’re meeting the timing.
What estate planning opportunities might distressed assets and investments present family offices?
Families can come to the table and be more aggressive with estate planning and shifting assets—or future growth of assets—out of their estate. If asset values today are depressed, whether they are securities or business assets, there are opportunities—assuming you believe that the asset values are going to increase over time—to shift a significant portion of that growth into vehicles that are exempt from estate tax.
The overarching point here, though, is estate planning starts with a plan. It doesn’t just start with, OK, I’ve got an opportunity now because I’ve got depressed assets. Let me do all these crazy gymnastics to begin to shift assets out of my estate. You’ve got to take a step back and think about—not only for you personally, but the family and different generations overall—what is your estate plan? Do you have a comprehensive plan? How does what you’re doing now fit into that plan and into your overall objectives? If you just start implementing strategies without starting with the basics and a plan, you’re probably not going to end up achieving your objectives.
With a family office, it’s even more important to have an overall strategic plan because you’ve got a large family with multiple generations, and the estate plans for multiple generations are intertwined with each other. When you think about it, there are members of the senior generation, who are in their 90s, who have likely done estate planning, and their assets are being allocated to various individuals, trusts, charities, etc. Then you’ve got their children, who are in their 60s, and their grandchildren in their 30s. The generation in the 60s isn’t going to achieve successful and effective estate planning without understanding what tools are already in place, what their parents have done, and how it’s going to impact them personally. It all has to work together. Within family offices, that’s the important piece. It starts with: What are the mission and foundational objectives of the family? The next step is taking that and layering it into each family’s personal objectives. Then each individual will craft a plan that not only meets their own objectives, but meets the overall objectives of the family.
If transferring depressed assets to another generation fits into a family’s overall plan, what are some important considerations?
If the assets are really distressed and the value is really low, but you don’t think the assets will remain depressed, then now is the time to transfer the assets. Because any gift made will likely include a relatively low valuation, you will utilize less unified credit. It makes a lot of sense for families to start identifying assets that have lost a lot of value and have remained really low. Shifting those assets into estate planning vehicles such as grantor-retained annuity trusts (GRATs) or other trusts makes a lot of sense. If a family has charitable objectives in addition to wealth transfer objectives, utilizing a charitable trust could be the perfect solution.
Another important consideration is to assess the assets being gifted. Families want to utilize assets that have the best chance to increase in value. You don’t want to transfer assets that are likely to remain depressed for a long time. If you transfer an asset that becomes worthless, you’ve wasted some of your unified credit on that transfer. That’s an important consideration.
Once a family determines that a transfer makes sense, what strategies might be appealing?
There’s straight-up gifting and utilizing trusts as recipients of gifts. There are also sales to defective grantor trusts—selling an asset to a grantor trust and taking back a note and, if structured properly, doing so on a tax-free basis. This is a powerful tool. The use of GRATs is another one that allows for the shifting of wealth to occur outside of an estate.
In a GRAT, let’s say $1 million in cash is put into a two-year GRAT. The IRS publishes on a monthly basis what they call a 7520 rate. It’s a rate of return that the government assumes you’re going to earn. Because this rate is based on market interest rates, the rate today is historically low (today’s rate is 0.6% as of June 2020). At the end of year 1, the grantor takes back $458,758; and at the end of year 2, the grantor takes back $550,509. Now, if the $1 million in that GRAT grew greater at 7% annually, the residual in the GRAT would be $103,520 that is now in the hands of the grantor’s children. This was accomplished without utilizing any unified exclusion amount. So what have I done? I have not made any gifts because I took back all the money I put into the GRAT. And I’ve been able to siphon off growth into a trust that’s now available to my children. So I essentially shifted appreciation or wealth out of my estate without using any gift exemption. If there are dividends paid or stock sold, then there is some tax to pay; but those taxes are paid by the grantor, not the trust, allowing the trust to grow tax-free. If you’re dealing in market conditions in which assets are depressed and the opportunity to grow is greater, you have a lot more potential for success when the Dow is at 20,000 versus when the stock market is at 30,000. That’s why using assets with depressed values in any estate planning strategy, whether it’s GRATs or other strategies, this is why the time is right—potentially—to take a hard look at that.