CAPITAL IDEAS: New taxes to know about

Tax proposals from as recently as June 2021 have changed, but Allen Harris is keeping tabs on them for you.

Tax proposals from as recently as June 2021 have changed. The stuff that could fall under this topic has filled months and months of news coverage. Today I will focus on some interesting ones you should be aware of. I’ll keep it brief, just so that you know we’re monitoring it for you.

The ABCs of ETFs

When relevant, I use this column to tell you the trades I made in my portfolios. Readers know that I primarily use exchange-traded funds (ETFs). I use ETFs for a few reasons. ETFs are usually “passive” investments that track indices. If you look at the record, index-based investing routinely beats portfolio returns of so-called active investors who try to manage a basket of stocks. As a result, ETFs often offer higher returns with less volatility. Also, I prefer ETFs to mutual funds because the average expense ratio is less.

But there’s another reason to prefer ETFs to mutual funds — tax advantages. At the end of the year, whether you invest in stocks or mutual funds, you must pay taxes on dividends paid and stocks sold (if there was a gain). Sure, passive ETFs trade less frequently than active managers, so you’d expect to pay less in taxes. But there’s more to it than that.

It’s complicated, but the gist of it is that you get a tax benefit on taxable events that occur within an ETF. Senate Finance Chairman Ron Wyden of Oregon proposed repealing this tax advantage to raise about $205 billion of tax revenue over a decade.

This ETF tax advantage goes back to the Nixon administration. The law exempts so-called regulated investment companies (RICs) from recognizing a taxable gain if shareholders are paid in securities instead of cash (known as payment “in-kind”). This is where it gets interesting — and by interesting, I mean “above my pay grade.” ETFs are set up so that money flows in and out through facilitators. When someone redeems their ETF, the sales by the fund manager almost always occur “in-kind.” If enough withdrawals occur by other investors, it makes it so that the ETF can avoid recognizing taxable gains entirely until the owner sells the ETF. A corporate ally will often move cash into the ETF then immediately withdraw it, allowing it to shed stocks that have gone up in value without incurring a taxable gain.

This proposal would exempt retirement accounts, so that’s good news. Other good news is that the proposal is far from a slam dunk as it potentially harms many small investors.

Even if it does pass, the benefits of ETF investing still outnumber the risks and negatives of investing portfolios comprised of individual stocks or mutual funds.

Death Tax Back from the Grave

The House of Representatives wants to close loopholes on the estate tax. The current federal exemption is currently $11.7 million per person. (It’s much less in some states, like the $1 million threshold for Massachusetts.)

The House wants to cut that exemption roughly in half, to $6 million. Further, it wants to end Grantor Trusts, which allows business owners to create a trust separate from their estate. The House plan would force new trusts to be part of the estate (but currently, there appears to be a grandfather clause). I suspect this one will become law.

Valuation Discount Planning

This isn’t used much, but it’s important enough to mention so that you know you can use it if it doesn’t get repealed. Discount planning allows investors to take a portfolio of financial assets into a partnership then gift it out to family in pieces. Each piece then gets discounted for tax purposes by up to one-third because it is a non-controlling stake. The IRS has tried to challenge this for years; the House plan would outright ban it.

For example, a $10 million asset can be placed into a family limited partnership (FLP). If you gave your granddaughter $1 million of that, you could do without giving her control. That lack of control means a lack of marketability, which means it’s worth less. Maybe that $1 million is now worth $500,000. Maybe $300,000. Let’s say you gave $1 million to each of your ten grandchildren. Suddenly that $10 million is worth, maybe $5 million – under the proposed threshold of $6 million. You save hundreds of dollars.

This is seriously at risk of going away.

Capital Gains Tax

The proposed capital gains rate has dropped from 39.6% to 25%. For the sake of small business owners who would want to sell their company to retire, thank goodness! That would have been devastating to people who toiled for decades to help and employ their community, forcing them to continue working as comfortable retirement eluded them. It’s all but a slam dunk that the capital gains rate will shift higher from 20% to 25%.

An Evergrande Market

I don’t like to wait until the last minute, so I tend to submit this column for publication days before you read it. In the stock market, days can be an eternity. Last week all eyes were focused on the stock market getting banged up. Last week started with the VIX, or “fear gauge,” spiking 20% on Monday, signaling that people were freaking out.

The news of the week was that Evergrande, China’s second-largest property developer by sales, would default on a debt payment. The story was that this crisis would be the unwinding of the global investment story, so stock prices took it on the chin.

I heard an estimate that for every 1% drop in Chinese Gross Domestic Product (GDP), global GDP drops by 0.5%. So, I suppose, investors should pay attention to what happens in China. And last week, the big news in China was the possible default, or outright bankruptcy, of Evergrande.

I don’t buy the story that Evergrande is the reason for any stock market correction. Sure, the market might correct as Evergrande is defaulting or unwinding, but correlation is not causation.

The stock market goes up, and it goes down, and just like when people said rain was the gods crying, we humans still feel comforted by pinning a fable to an event. Between the time I write this column and you read it, the stock market could have gone down 5%. Or it could have gone up 5%. I don’t know. I do know that no matter which of those two possibilities play out, it’s not because of Evergrande — even if the financial news media is carrying that story through the news cycle. Look, I’m not damning the financial news media. Like the geek that I am, I watch CNBC and Bloomberg all day long. They’re valuable tools. But know who’s on the news? Humans — humans who feel comforted when there is a story to explain what’s going on.

“OK, then, Harris,” you ask, “why did the stock market go down?” Who knows? Who cares? It’s been a 4-week wiggle, thus far resulting in a 5% correction. Doubling that amount wouldn’t be out of the ordinary. Do you buy the dip? Last Monday, the day the fear gauge spiked 20%, I wired money from my checking account to my trust accounts to get cash invested into the equity market. Even if it is Evergrande’s fault the stock market is down (which it isn’t), and even if the stock market drops another 5% after I get my cash invested (which it might), I clearly expect the dip will be a good buying opportunity.

There are lots of reasons for another month of falling stock prices. October is known as the month when the stock market makes big drops. Stocks are not invulnerable to more losses. Nonetheless, I am investing my own cash during the middle of the ongoing debate of how far stocks prices will decline because the structural tailwinds are in place for the market to continue rising after a correction.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing investments of more than $500 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures. Direct inquiries: aharris@berkshiremm.com.