Family Wealth Management: Key Strategies for Corporate Executives

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1 Family Wealth Management: Key Strategies for Corporate Executives The demands of running a public company don t leave corporate executives much time to ponder their personal balance sheets. Yet sustaining the wealth they have built poses unique challenges. Often they hold illiquid assets and concentrated positions in the businesses that employ them. Their ability to diversify is constrained by federal law, corporate trading policies and how the market might perceive large sales of their equity positions. Executives have many of the same concerns as other wealthy individuals, notes Samuel Gallucci, Director, Financial Planning Initiatives at Morgan Stanley Smith Barney. They want to provide for their current and future financial well being, transfer wealth to the next generation in a tax-efficient manner, and perhaps design a charitable legacy. Which planning tools are appropriate in a particular situation will depend on an individual s assets, liquidity needs and objectives. The following are six strategies that Financial Advisors at Morgan Stanley Smith Barney think are worth considering. Diversify Out of Concentrated Positions in Company Stock A critical issue for senior executives, whether they are in the prime of their careers or approaching retirement, has always been the enormous amount of their wealth tied up in company stock. These are some of the ways to diversify or reduce the risks of a concentrated position. 1 Diversification does not assure a profit or protect against loss in declining financial markets. Margin loan. The simplest way to diversify is to borrow against a concentrated position and invest the proceeds, says Gallucci. Typically loans can be made against the value of the stock. If that value declines drastically, it might be necessary to sell shares to cover the debt. Preset diversification program. Executives who actually want to reduce their holdings of company stock rather than just add other investments to their portfolios often engage in a Rule 10(b)5-1 selling program. These programs, permitted under a 2001 amendment to the securities laws, essentially put diversification on auto-pilot, says Joseph Vaccarino, Managing Director Product Management, Corporate Client Group, at Morgan Stanley Smith Barney. They involve an agreement between a broker-dealer and a corporate insider or key employee for future sales of shares on specific dates at preset prices. For example, Vaccarino says, an order to a broker charged with implementing the plan might say, Please sell 10,000 shares on the first trading day of the month for the next two years. The program, put in place in good faith at a time when the executive is permitted to divest, allows executives to diversify free from concerns about blackout periods and allegations of insider trading, says Vaccarino. These programs can be used with a variety of ownership interests, including restricted stock, employee stock purchase plans, founders shares and stock options. Executives must, of course, confer with the corporate counsel of their employer before entering into such a program. Tools to help mitigate risks. Company rules may restrict current employees from engaging in other strategies, designed to reduce the risks of concentrated positions. When corporate policy permits it or the executive has left the company, the following other options may be available: Exchange Funds. Exchange Funds fall within a category of assets generally referred to as Alternative Investments. Alternative Investments are speculative in nature and include a high degree of risk. An investor could lose all or a substantial amount of his/ her investment. Alternative Investments are suitable only for eligible, long-term investors who are willing to forego liquidity and put capital at risk for an indefinite period of time. With this technique an exchange of one company s stock is made for a position in a fund that includes that stock, as well as the stocks of other companies. When structured properly, the contribution of

2 the stock to the fund does not create an immediate taxable event. An investor in the fund will typically receive a diversified basket of securities when it redeems its interest in the fund, as long as it has maintained its interest for a certain period of time typically five to seven years later, depending on the fund s rules. Tax gains can generally be deferred until each individual security is sold. Collars. This strategy combines the purchase of a put with the sale of a call maturing on the same date (typically two or three years later) to minimize risk and deliver some upside potential. If the stock falls below a certain value, it is put to another investor at a preset price. If it goes above a specific level, it gets called away. Tax straddle rules may apply to these types of transactions. We would suggest speaking with a tax advisor prior to entering into this type of arrangement. If the stock volatility is fairly stable, what is paid in put premiums is generally offset by the premiums that are received on the call side, Gallucci says. Prepaid forwards. These contracts between an investor and a bank allow for borrowing against the concentrated position for a period of time, after which the position is closed out and either cash or the shares are delivered. Meanwhile, the borrower receives a certain percentage of the current value of the stock (typically 80% 90%) while retaining flexibility about how to reinvest the proceeds. Prepaid forwards have come under close scrutiny from the Internal Revenue Service ( IRS ), which is believed to have begun an initiative targeting such contracts. Again, we suggest seeking the guidance of a qualified tax advisor prior to entering into this type of arrangement. Decide Whether to Defer Compensation Theoretically, the longer an employee can afford to defer compensation the better, because deferring the compensation postpones the current income tax liability. Assuming a long enough deferral period and a long enough tenure at the company, some employees think of deferred compensation as a pocket of money they can draw on when they retire, while others see it as a way to support certain nearer term objectives while they are still employed, says Gallucci. Either way, keep in mind that federal law generally requires executives to notify their employers of any election to defer compensation far in advance of when they actually receive the income. They must specify the form in which they want to receive it (lump sum or installments), as well as the timetable for the payments. Like other financial decisions, choices about deferred compensation depend on a number of factors, Gallucci says. Employees will want to consider both their current liquidity needs as well as what they expect their needs to be in the future. One wild card is what the income tax rates will be when the funds are withdrawn, Gallucci notes. Although people make deferred compensation decisions based on today s income tax rates, those rates could be considerably higher in the future. Another uncertainty involves the financial future of the company. Most types of deferred compensation are subject to claims of the company s creditors, so if the business does poorly, the employee s payment might be forfeited, Gallucci notes. The longer the deferral and the larger the amount deferred, the more executives subject themselves to that risk. Look for Opportunities to Make an 83(b) Election If a compensation package includes stock options, the company s stock option plan may permit an early exercise of unvested stock options; what is known as an 83(b) election a reference to the section of the Internal Revenue Code that permits this strategy. Making the election permits executives to report the income and pay the tax before the options vest. The advantage of making this election is that you pay ordinary income tax on the value of the options in the year in which you make the election, and any appreciation after that is considered capital gain, Gallucci notes. The top tax bracket for ordinary income is currently 35%, and the long-term capital gains rate is 15%. The employee must file Form 83(b) with the Internal Revenue Service within 30 days of the date of exercise. Still, there are potential disadvantages of making an 83(b) election, Gallucci notes. For example, if the value of the options goes down, the executive will have paid more in tax than if the election had not been made. Also, if the options never vest because the executive leaves the company, he/she will have paid tax on compensation never received. It s important to weigh all these factors in deciding whether to make the election. Transfer Stock Options to Family Members Although incentive stock options cannot be transferred, stock plans of a growing number of public companies permit the transfer of vested nonqualified stock options to family members or to trusts for their benefit. These options can make a very tax-efficient gift. If the options are exercised while the executive is alive, the executive, rather than the individual(s) or trust to whom the executive had given the options, is responsible for paying the income tax. The executive pays income tax (at ordinary income tax rates) on the spread the difference between the strike price and the fair market value of the stock on the date of exercise. By paying the income tax, the executive confers an estate planning benefit. It s a way of making an additional gift to family members without gift tax, Gallucci says. And any subsequent appreciation of the stock is eligible for capital-gains treatment, with the holding period starting on the date of exercise.

3 Leverage Other Lifetime Gifts to Family Members One of the most compelling reasons to make lifetime gifts has always been the prospect of removing assets, along with any subsequent increase in their value, from a donor s estate. Currently, individuals can give up to $13,000 in 2011 each year to as many recipients as they would like without incurring a gift tax; this amount is referred to as the annual exclusion amount. Spouses can combine their annual exclusion amounts to give up to $26,000 to any person without incurring gift tax. One way to leverage an annual gifting program is to use it to fund life insurance. Individual family members can buy the policy directly using gifts to pay the premiums. Alternatively, gifts can be made to an irrevocable life insurance trust ( ILIT ), which in turn can buy life insurance. Either way, this gifting program will have achieved leverage because the gift is only the premium payments, not the full policy proceeds. When an individual s gifts exceed the annual exclusion limit, they count against the individual s $5 million lifetime gift-tax exclusion the total amount of taxable gifts each person can make without incurring gift tax. Once an individual s gifts have exceeded this limit, the individual must pay tax on any additional gifts. However, the individual could maximize the use of the exemption by making gifts that have little or no gift-tax consequences, and by transferring assets whose value can be discounted, says Gallucci. Executives may wish to consider the following estate planning tools: Intrafamily loan. This is a documented transaction that typically involves senior family members lending funds to more junior ones or to a trust for their benefit. To avoid triggering gift tax, the loan must bear interest at the applicable federal rate ( AFR ), set and published each month in a bulletin published by the U.S. Treasury Department. Family borrowers can use the loan proceeds for a number of purposes. They can buy real estate or invest in a new venture, for example. If the return on the investment is greater than the AFR, they can keep the difference, free of any gift tax. This strategy is especially attractive when rates are low. Grantor retained annuity trust ( GRAT ). The person setting up the trust, known as the grantor, contributes appreciating assets to an irrevocable trust and retains the right to receive an annual income payment (an annuity) for a specific term. If the grantor survives the term a condition for this tool to work any property left in the trust passes to family members or to trusts for their benefit as specified in the GRAT. Calculating the value of the annuity requires the use of an Internal Revenue Service hurdle rate. Known as the Section 7520 rate and published monthly by the U.S. Treasury Department, it is based on a basket of outstanding treasury securities. It is possible to set up a GRAT that results in no taxable gift or at least a very nominal one. Qualified personal residence trust ( QPRT pronounced CUEpert ). This strategy removes the current value of a home and all future appreciation from the estate. To employ the strategy a primary residence or vacation home is transferred into an irrevocable trust of which the grantor would typically be trustee with the grantor retaining the right to live there for a specified number of years. During the term of the trust, the grantor continues to be treated as the owner of the property for income tax purposes. When the term expires, ownership passes to the beneficiaries of the QPRT (usually children). If the grantor dies before the trust has terminated, the residence will be included in his or her taxable estate. While the retained interest in a GRAT is reflected in the annuity, with a QPRT the retained interest is the right to continue using the home. The potentially taxable gift with the QPRT reflects the value of the right to receive the residence (the remainder) a certain number of years in the future. Computing the value of the gift involves a complex actuarial calculation based on the Section 7520 rate. As with a GRAT, if the grantor dies during the trust term, the benefits of this technique are eliminated. Installment sale to a grantor trust. With this popular alternative to a GRAT, senior family members sell assets to a trust that will benefit younger relatives, and in exchange take back an interestbearing promissory note. Assuming a sale at fair market value and interest at the AFR, the sale will result in no gift, and therefore no gift tax. Like a GRAT, this transaction involves what s called a grantor trust so named because the grantor retains certain rights or powers so the trust will not be treated for income tax purposes as an entity separate from the grantor. As a result, the grantor, rather than the trust or its beneficiaries, must pay income tax on trust earnings. By paying the trust income taxes, the senior family member in effect makes an additional tax-free gift to the trust beneficiaries. If the grantor dies before the note is paid in full, then only the unpaid balance of the note may be included in the grantor s estate. Family limited partnerships ( FLPs ) and limited liability companies ( LLCs ). These entities enable family members to make tax-efficient gifts to each other while reducing and consolidating their investment costs. To do that, a family member (assume it s the parent) transfers assets to an FLP or LLC. Next, the parent sells or gifts some or all of her limited partnership interests in the FLP or interests in the LLC to family members or to trusts for their benefit. When valuing the interests that she transfers, substantial discounts may be available. These discounts reflect that the interests cannot be readily sold to people outside the family and lack control over the FLP or LLC. By transferring assets such as stock or stock options to the partnership and then transferring shares in the entity, rather than giving away the assets directly, the parent potentially reduces the gift tax value of the assets passing to the next generation, thereby making the exemption amount go further.

4 Donate Appreciated Assets to Charity Gifting to Charity. If a donor is charitably inclined, making gifts of appreciated property, such as company stock, may prove more beneficial to the donor than selling the appreciated property and donating to the charity the resulting proceeds from the sale. The benefits of each alternative can be calculated to help determine which alternative has the greater income tax benefits to the donor. More specifically, one would compare whether it is more advantageous to sell the appreciated asset, pay the corresponding capital gains taxes resulting from the sale, donate the after-tax proceeds and obtain a charitable income tax deduction for those proceeds; or donate the appreciated property, thereby not incurring any capital gains tax, but resulting in potentially less of a charitable income tax deduction. By selling the appreciated property and donating the proceeds from the sale to a charity, the donor will likely pay capital gains taxes on the sale but then may be able to obtain a charitable income tax deduction of up to 50% of his/her adjusted gross income ( AGI ) for the cash donated to a public charity or 30% of his/her AGI for the cash donated to a private foundation. On the other hand, by donating the appreciated property directly to the charity, the donor will not incur capital gains taxes but may only be able to obtain a charitable income tax deduction of up to 30% of his/her AGI for donations to a public charity or 20% of his/her AGI for donations made to a private foundation. Also, deductions of shares other than unrestricted publicly traded stock may be limited to the donor s basis rather than the fair market value of the stock. Charitable Remainder Trust. Benefiting charity through a charitable remainder trust also can be a powerful diversification tool, Gallucci notes. Since the trust pays no income tax, there s no capital gains tax due when it sells appreciated assets and reinvests the proceeds in a diversified portfolio (the capital gains tax is deferred and allocated over the payments made for the term of the trust). At the same time, charitable remainder trusts provide noncharitable beneficiaries (the executive and his or her spouse, for instance) with annual cash payments either for a term of years or for the lifetime of one or more family members. When the income interest ends, the remaining assets pass to the charity of the grantor s choice, which may include the executive s own private foundation. When setting up the trust, the donor can take an income tax deduction for the value of the charity s remainder interest. however, get a deduction each year for the money that is distributed to charity. If the trust earns more than it must pay out, the money gets added to the principal and eventually goes to family members without incurring gift tax. These strategies should be considered in the context of an individual s total financial picture and personal goals, Gallucci says. We look at clients not just as executives, but as spouses, parents, siblings and support centers for senior members of their own families. Morgan Stanley Smith Barney works with each executive to develop a highly customized plan geared toward the individual s diversification objectives, liquidity needs and wealth transfer goals. Written by Morgan Stanley Smith Barney Wealth Planning Services, Samuel Gallucci, Director, Financial Planning Initiatives, with additional contribution from Joe Vaccarino, Managing Director, Product Management, Corporate Client Group. Contact Your Morgan Stanley Smith Barney Financial Advisor At Morgan Stanley Smith Barney we review carefully every aspect of your wealth with the goal of helping you manage your lifestyle, control your risks and take a strategic approach to what you own as well as what you owe. Your Financial Advisor can tap a vast pool of professional knowledge, including specialists in family dynamics, estate planning, insurance, liabilities management, as well as portfolio analysis, traditional and alternative assets, and tax-sensitive investing. Our Specialists will review information provided by you to help identify the strategies best suited for you and your family. Our recommendations are objective, without bias toward one product or another, and are designed to work in concert with other strategies you may already have in place. Your Morgan Stanley Smith Barney Financial Advisor is committed to helping you prepare for the future. We look forward to working with you. Charitable Lead Trust. A charitable lead trust is the reverse of a charitable remainder trust. With this trust, a charity gets its payout up front for whatever period of time the donor specifies, although it may also last for the lifetime of the donor, his or her spouse, or their descendants. When this lead interest ends, the noncharitable beneficiaries, usually family members, get what s left, known as the remainder interest. With a nongrantor trust a popular way of setting up the charitable lead trust an executive would not need to report any trust income on his or her personal income tax return the trust would be a separate taxable entity. The trust would,

5 1 Many senior level executives may be considered insiders and therefore transfer of their stock may be restricted for securities law purposes. The subject of transactions involving restricted stock is beyond the scope of this document. 2 Preset Diversification Programs ( PDP ) Important Considerations - PDPs should be approved by the compliance officer or general counsel of the Company - A PDP may require a cessation of trading activities at times when lockups may be necessary to the Company (e.g., secondary offerings, pooling transactions, etc.) - A PDP does not generally alter the restricted stock regulatory requirements (e.g., Rule 144, Section 16, Section 13D) that may otherwise be applicable - PDPs that are modified or terminated early may weaken or lose the benefit of the affirmative defense - Public disclosure of PDPs (e.g., via press release) may be appropriate for some insiders - State insider trading laws are not preempted by Rule 10b5-1 and must be considered on a case-by-case basis - Most companies will permit PDPs to be implemented only during open window periods - Morgan Stanley Smith Barney, as well as some issuers, imposes a mandatory waiting period between the execution of the PDP and the first sale pursuant to the PDP This material is based on generally available public information and is provided free of charge for general informational and educational purposes only. The information contained in this material is subject to change without notice. Morgan Stanley Smith Barney LLC undertakes no obligation to update this material. This material does not take into account your personal circumstances and we do not represent that this information is complete or applicable to your situation. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice. This material was not intended for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters Morgan Stanley Smith Barney LLC. Member SIPC. NY Cs PSC04/11 GP P-N06/08