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| Decision 2004 |
When the Levies Break
Dwight Cass
09/01/2004
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Just shy of 12 years ago, in the immediate wake of Bill Clinton’s election
victory, Norman Brinker, then the chief executive of the country’s
second-largest restaurant group, exercised more than 175,000 Brinker
International stock options and sold the shares he received for a profit of $6.2
million. Robert L. Callaway, Brinker’s general counsel, explained to worried
shareholders that Brinker had not suddenly lost faith in his company. Rather, he
told the Wall Street Journal, the president-elect’s soak-the-rich tax rhetoric
prompted the move. “The specter has forced personal tax planning on Mr.
Brinker,” Callaway said. “It’s that simple."
 It was a specter that spooked
many high-level corporate executives, family business owners and angel
investors, who scrambled to exercise share options, accelerate income or
rebalance their investment portfolios before Clinton’s promised tax increases
could go into effect.
Today, many of us find ourselves facing a similar
conundrum: We may own very valuable, low-basis assets such as family businesses
or concentrated stock positions, which will likely be subject to higher capital
gains taxes under the next presidential administration—be it Republican or
Demo-crat. Alternatively, we may have income that would be whittled away by the
higher income taxes that John Kerry has promised to levy on the affluent.
Whichever candidate occupies the White House next January, however, most experts
concur that there is a better than even chance that the deepening federal
deficit will force the chief executive to increase tax rates (see “Paying for
Lunch,”). And if Kerry carries the day, he is expected to at least
attempt to roll back some of President Bush’s tax cuts.
TOP VIEW
If we believe the next administration will seek to staunch the flow
of governmental red ink by raising taxes, we may want to fine-tune the timing of
our financial transactions. However, in most cases, this specter should not
dictate their substance. Even so, we may wish to modify the terms of our family
business sales, our tactics for the disposition of our concentrated stock
positions or the timing of our securities portfolio asset reallocations, in
light of the potential for higher taxes after the election. |
The Long View
Private bankers advise us never to make important financial
decisions solely because of their tax consequences. Accelerating a transaction
we already contemplate—say, exercising options to diversify our assets,
reallocating our securities portfolio because of rising interest rates or moving
forward the close date on the sale of our business—may make sense, but
transactions timed solely to dodge tax-law changes are almost always
counterproductive.
This becomes apparent once we crunch the numbers. John
Goldsbury, director of executive advisory services in the private bank at Bank
of America in New York, notes that, when we sell to avoid taxes, we are “simply
restarting the capital gains clock.” We must reinvest the money we garner from
the sale into another asset, which itself becomes subject to capital gains
taxes. “You have to bear the second tax, rather than letting the investment
ride,” Goldsbury says.
A sale to avoid higher future capital gains taxes may
prove to be penny wise but pound foolish over time. If we own an investment that
yields 7 percent a year, and capital gains taxes are expected to rise from 15
percent to 20 percent (for example, if Kerry rolled back the Bush tax cuts),
selling to avoid those additional 5 percentage points of tax makes no real
sense—unless we planned to sell the asset for other reasons (to rebalance our
portfolio or to reduce risk, for example), Goldsbury notes.
Balancing our
long-term investment objectives against the short-term tactical gains we may
reap from selling before taxes increase will allow us to weigh our options
logically. With that proviso in mind, the potential for capital gains, dividends
and income tax increases next year may bear on our decisions regarding the
economics or timing of a number of different types of transactions.
Securities If we decide to reallocate our assets—say, we want to shorten the
duration of our fixed income portfolio in light of rising interest rates, or we
plan to put more of our money into alternative investments—now is a good time to
execute the changes, since we will benefit from the low capital gains tax rate
on the assets we sell.
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