How other potential tax increases should bear on our decision making is somewhat less clear. The dividend tax, currently 15 percent, is one example. Dividend-paying large cap stocks are becoming increasingly popular as the economic cycle progresses from recovery to a more stable growth period, in which large companies tend to outperform. If the dividend tax rate goes up, this could affect the market value of these securities. However, we are unlikely to witness a wholesale shift from dividend-paying securities to growth or value stock due to tax changes; investors tend to decide among these options based on their expectations of market performance, which is largely determined by the economic cycle. “We have not yet seen people decide against dividend-paying stocks because of the possibility of taxes,” says Robert Seaberg, managing director of wealth planning and philanthropic services at Smith Barney in New York.

“If you are looking to change the risk profile of your asset allocation by switching into stocks and bonds, then it is a good idea to do so now.”

The income tax rate may also affect our portfolio allocation decisions. If the rate rises, we may want to reconsider our weighting of taxable versus tax-exempt debt, and reallocate our portfolios in favor of the latter, which becomes more valuable, explains John Nersesian, managing director of wealth management services at Nuveen Investments in Chicago.

To compare the two, we need to calculate the tax-exempt debt’s taxable equivalent yield (how much it would have to yield if it were taxable in order to be worth the same as it is now on an after-tax basis). “If we look at a high quality annuity today paying 3 percent, assuming a marginal tax rate of 35 percent, the taxable equivalent yield is 5.38 percent,” Nersesian says. If taxes rise, that same annuity will be worth more. “If we look at a 45 percent top income tax rate, that same annuity yielding 3 percent provides a taxable equivalent yield of 6.36 percent. So the investor picks up, if you will, about a full percentage point in terms of after-tax or taxable equivalent yield.”

“A charitable contribution today, in a world of 35 percent marginal tax rates, is less valuable than a charitable contribution I make next year or the year after, if tax rates were to rise to 40 or 50 percent.”

Family Businesses With two out of five family companies expected to change hands in the next half-decade, tax timing could become as important for business owners and investors this year as it was in 1992. “On the family business side, we are hearing and seeing a number of folks doing partial or full liquidity events now, rather than waiting,” says Smith Barney’s Seaberg. He says these individuals are taking an extraordinary distribution through the sale of all or part of their businesses, believing that the combination of a low-tax tax environment and the benefits of the economic recovery enables them to command a higher price for their assets—and retain the lion’s share of it after taxes. “The odds of things getting better are not very good,” he warns.

This has not turned into a stampede, however, because many business owners who might have sold during the 2001-2002 recession now view their companies as much better investments. “If you’re in a business that’s going to benefit from this recovering economy, you may want to wait to sell, because the value of the business may go up far more than what you would have to give up by paying a little more in capital gains tax,” notes Bill Carter, president of Carter Advisory Services in Dallas.

“We are hearing and seeing a number of folks doing partial or full liquidity events now, rather than waiting.”

If we have already negotiated to sell our family business, or to bring in a partner (such as a private equity firm), we may wish to bring the payment forward to avoid any potential tax increases. If we have negotiated installment payments, we may want to accelerate or front-end the installments as much as possible.

Tax concerns may also play a part in the growing interest in leveraged recapitalizations. In a leveraged recap, a business owner takes equity out of his or her company’s capital structure, usually through a dividend, and replaces it with debt. Rising interest rates may be one reason to undertake a recap—business owners want to lock in a lower cost of capital—but the current dividend tax level is another. If we anticipate the need to take some capital out of our family business and fear that dividend taxes may rise under the next administration, this may be a good time to consider one of these transactions.

Concentrated Stock Positions Many of us find ourselves with much of our value tied up in a single stock, perhaps after we take our company public or sell it to a firm that pays us in its own shares. Of course, this subjects us to both liquidity and market risks. We may find ourselves unable to obtain the liquidity we need for other investments or to support our lifestyle, and we are dangerously overexposed to the fortunes of the one company. Also, from an investment perspective, holding one stock is usually a poor bet. The volatility of an average stock is three times that of a diversified large cap portfolio, and high-volatility assets grow more slowly. (Of course, those who have owned Microsoft stock since its IPO may beg to differ! However, generally speaking, this is true.)

In a case like this, selling a concentrated position and redeploying capital into more liquid and diversified assets makes sense, apart from tax implications, says Wes French, executive vice president at Wilmington Trust in Atlanta. If we can do so under a lower-tax regime, all the better, French says, but that is always a secondary consideration.

Hedging one of these positions is an alternative to selling outright; it essentially postpones the sale. If we want to hold onto the position for personal reasons—say, we wish to remain involved in a company we founded—or we have agreed to a lock-up period and are unable to sell, then hedging the positions to avoid the risk of a serious capital loss certainly makes sense. However, if we hold the positions purely for their investment potential, hedging them may prevent us from diversifying our portfolio, and postponing a sale exposes us to the threat of higher tax rates.

Selling outright is also cheaper and easier than hedging. The market’s recent volatility has pushed up the prices of the derivatives used to hedge stock positions, making many of these techniques costly, notes Holly Isdale, managing director and head of the private banking advisory group at Lehman Brothers in New York. Also, if we are company insiders, it is often easier to explain to other shareholders and the public that we need to sell for tax reasons, or as part of our estate planning, rather than to explain why we are hedging against a decline in our own company’s fortunes.

We may also want to consider the effect of higher taxes on the market’s performance, and by extension, the valuation we may be able to secure for our shares, according to Robert Elliott, senior managing director at Bessemer Trust in New York. Tax increases can hurt investor confidence—although this is not always the case, as the rally after the Clinton tax increases showed. “Our recommendation used to be that our clients should hedge some part of their position, using prepaid forwards, exchange funds or other mechanisms,” Elliott says. “Now we are advising clients to sell the positions, or sell at least part of them, through some type of disciplined program.” Bessemer still prices collars and prepaid forwards for clients, though usually on a tactical basis as a bridge to a sale that is already planned, he notes.

Real Estate Those of us with significant concentrations of wealth in real estate, like those with concentrated stock positions, who want to diversify into other asset classes, may want to act now to avoid the risk of higher capital gains taxes. Also, depending on our age and goals, there may be strong economic reasons to consider diversification. “I have several clients who are real estate developers in their mid-50s, [who have been] rolling cost basis from one property to another,” French notes. “If you are looking to change the risk profile of your asset allocation by switching into stocks and bonds, then it is a good idea to do so now.” REITs are offering developers attractive prices for properties; there is also the worry that real estate prices may have plateaued in some markets. In light of those concerns, a more diversified portfolio can look more attractive. Carter agrees. “It’s a great opportunity for people to take large nonincome-producing assets and convert them into some kind of income-producing assets,” he notes.

Options and Compensation Like Norman Brinker or Michael Eisner in 1992, many of us have a great deal of our wealth held in the form of vested, in-the-money stock options. If we fear that income taxes will rise, it makes sense for us to exercise these options sooner, rather than later, Nersesian says. “Whether they sell the stock or hold it, the IRS takes its pound of flesh at the time the option is exercised. If we believe that tax rates are potentially heading higher next year or down the road, it may make sense for investors who have options, and specifically those that are maybe approaching their lapse date, to consider an exercise currently with a maximum rate of 35 percent versus an exercise down the road at a higher rate,” he argues.

There is an important caveat about options: These instruments are, by their nature, leveraged investments—they usually rise or fall in value more rapidly than the underlying stock. This can be a boon, as long as we understand that the leverage increases both our potential return and our potential for loss. When we exercise options, we give up that leverage advantage, Bank of America’s Goldsbury notes.

We may also want to consider accelerating the receipt of other income. We may want to ask our employer to pay our bonus in December, rather than January, or we may want to offer our clients a discount to settle our invoices in the fourth quarter, rather than in the first. However, since we do not know which taxes will rise, or by how much, it is difficult to decide how much in-come to forgo. “In this case, there is not a terribly strong indication that ordinary rates will go above 35 percent,” notes Bill Baldwin, president of Pillar Financial in Waltham, Mass. “I don’t have the sense that anyone is rushing to accelerate income into this year.”

Charitable Contributions Income taxes may also affect the economics of our charitable donations. “For the investor who is considering making a significant charitable contribution to his alma mater, or to build a wing at the hospital, we’d suggest that he consider delaying,” Nersesian notes. “A charitable contribution today, in a world of 35 percent marginal tax rates, is less valuable than a charitable contribution next year or the year after, if tax rates were to rise to 40 or 50 percent.”

Illustration by Matt Mahurin.

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