Written by Robert Bingham, CFA - Defensive Investment Advisor
The extraordinary measures taken by the United States Federal Reserve to stimulate employment growth has resulted in substantial price appreciation of bonds during the last 4 years. Investors who owned bonds have seen appreciation of their holdings across market sectors including high-yield, high-grade corporate, government and municipal issuers.
But experienced bond investors are becoming increasingly concerned about the impact rising interest rates will have on their bond portfolios when the Federal Reserve decides stimulus measures are no longer warranted. While the Fed has announced that we will see additional Fed intervention in the bond market for the foreseeable future, at some point they will step away from the market and bond prices should fall.
How bad could it be? Consider that in 2011, the ten year Treasury bond started the year with interest rates near 4%. By year end, rates had fallen to 1.86%. Accordingly, the ten year Treasury appreciated by 17%. In a reversal, it would be reasonable to expect long term bonds to decline by 17% or more.
So what can bond investors due to protect themselves? There are a variety of fixed income tactics that can be employed:
1. Avoid bond mutual funds and buy individual bonds with laddered maturities. When interest rates rise, most bond prices fall. Owners of individual bonds can expect their principal to be returned to them through interest payments and bond redemptions; bond mutual fund holders have no such assurance. As rates rise, mutual fund prices will fall, and investors will need to sell fund shares at depressed prices to obtain liquidity.
2. Buy premium bonds with high coupons priced to a short call date. "Kickers" are a conservative way to generate above market income, while protecting investors from major price adjustments if rates rise modestly. The bonds' prices are generally less volatile than the market because they will probably come due before maturity due to the short call date and high coupon.
3. Invest in variable rate bonds which pay interest tied to a recognized index like US $ LIBOR . Currently, many of these issues have coupons that are near zero percent. So, like the “Zero Coupon Bonds” that they currently resemble, they trade at a discount to par. But when rates rise, they will pay more interest and begin to resemble bonds with regular coupons. Prices are likely to rise to par value when this happens. There are a limited number of these bonds outstanding. So when they are in demand (and in a rising rate environment, they should be in great demand), they should move higher in price. So in the worst case, you own a discounted bond which over its life should appreciate to par and earn an attractive return. But when rates rise, the bonds should appreciate quickly, which will help to offset the principal losses of the fixed coupon instruments in a bond portfolio.
Example: GE Capital has bonds available in $1000 par increments which mature in 2036 and pay Quarterly US $ LIBOR + .48% . (LIBOR is currently .4345%.) The bonds trade at a price of 76 or $760 per $1000 par and pay a coupon of .9145% or $91.45 per thousand (a/o 10-8-12). If Quarterly US $ LIBOR were to rise from .4345% to 5%, they would pay 5.48%. Over the same term, we would expect the bonds to trade higher to around par, giving investors capital appreciation of 24 points or around 32%.
4. Buy short term, “junk bond issues” which mature in 3 to 5 years. There are many well-managed companies, particularly in the “mid-cap” universe, which offer good yields. These are “junk” issuers, but many have reasonable financial characteristics, limited annual redemptions to refinance, and yield attractive returns. Clearly, investors need to diversify their portfolio holdings; but it is worth the effort. Investors can earn an additional +/- 2 percentage points of return by taking risk that can be, for the most part, diversified out of a portfolio.
Buying individual bonds and implementing these strategies in parallel with other traditional fixed income portfolio tactics can generate good return and cash flow, provide protection from rising rates and reduce risk by adding additional sector and industry diversification. And most importantly, they should help you to survive the bond bear market which is likely to unfold over the next ten years.
Robert Bingham is the founder, President and Chief Investment Officer of SKY Investment Group, a privately-held investment management firm based in Hartford Connecticut. The firm provides direct-instrument equity and fixed income portfolio management to private clients and their families. Mr. Bingham holds a joint BA in Mathematics and Economics from Middlebury College. He is a Chartered Financial Analyst and a member of the New York Society of Security Analysts. He has been managing assets for private clients and their families for 26 years. For further information on SKY, visit their website at www.skyig.com.
Gail Rosen, CPA, is president of Gail Rosen, CPA, PC in Martinsville, New Jersey. She has been a practicing CPA for over 30 years. She is a popular speaker for business organizations, community groups and government agencies, and sits on the Board of Directors for several highly respected organizations.
She is similar to many CPAs this time of year. She is fine tuning her staff to make sure the workflow is perfectly orchestrated, updating her software to assure returns are filed efficiently and working closely with her clients to make sure all projections are accurate. However, amidst the similarities, Rosen is different. She recognizes the evolving, competitive world of tax and operates in it accordingly. Aside from being on the State and Federal Tax committee for the New Jersey Society of Certified Public Accountants to stay up-to-date with current tax code, ‘Rosen is utilizing modern Web-based tools such as LinkedIn to maintain active relationships with her clients. Gail Rosen reveals what she is doing to prepare for tax season 2012. Q. Are you utilizing Tax Organizers this year mailed out or e-mailed? A. What we do is we mail them out but we also ask people if they want an e-organizer, which is what we call it, and we’d be glad to send it to you. We do mail and e-mail only on request.
Q. What percentage of your clientele comes to your office?
A. I would say about 35%.
Q. How much time do you spend with them on average?
A. Of course it varies, but I’ll probably spend an hour but I’m actually doing the return as I’m meeting with them so the return is virtually done except for any open points. Then, it just has to go through a review by one of my staff. So I’d say an hour.
Q. Do you use document management tools to scan over documentation?
A. Yes, everything is paperless. We’re inputting the W-2 and then we’re scanning it.
Q. Does your software scan in and populate the 1040 with W-2 information?
A. No, I tried that once a few years ago, I didn’t try it again. We haven’t tried it again because we tried it once and it was awful although I heard it got better. We’re so good and it goes so quickly just inputting it that when you scan it you have to figure out what went wrong. It almost takes more time to review it and make sure it’s right than to put it in the first time.
Q. Do you have any other technological time-saving tips?
A. We use Constant Contact. That’s probably my most favorite thing because it has e-mail updates on the new tax law. A lot of people are now alerting us because my name is in front of them all the time so when they get my updates it makes them think about me or any of the problems we may encounter over the year. That’s probably one of the best things I do all year. It triggers problems that I can fix during the year.
Q. Do you recommend any tax update courses?
A. One of the best things I like, I love, is being on the e-mail discussion lists where people post questions and updates because that’s always up-to-date and they’re real-life problems. I take courses all the time and I’m on tax committees. Like I’m on the State and Federal Tax committee for the New Jersey Society of Certified Public Accountants so that’s probably one of my favorites because it has all the people that really know what’s going on.
Q. What do you see as good advice for clients before year-end?
A. Basically in today’s economy normal isn’t the usual. Life is crazy so your taxes are crazy. You have to know projections so you can plan because everyone has so much going on. Everyone’s situation is different; someone will be unemployed, someone will be starting anew. Each situation has to be analyzed; not everyone just goes to work, has the 2.5 kids and the white picket fence.
Q. Do you have any advice for other CPAs to make tax season run more smoothly?
A. The best advice is staff. Each and every staff person has to be good and if they’re not good then get rid of them cause it will bring you down. There’s nothing more important than your staff because good staff are the good products and the clients will come. And don’t be scared to change; things are constantly changing and you got to change with it. Don’t be scared of change. You shouldn’t be scared of social media because that’s the way of the future, that’s how people communicate. You’re able to reach mass audiences at one time. Spend some time and money to do that because in the long run you’ll save money.
Q. How would you utilize social media to help things go well during the season?
A. I send out a newsletter all the time to my clients. I’m constantly aware of new things so I tell them in my e-newsletter. I’m always tweeting and I link it to my LinkedIn so that my contacts and the people on my LinkedIn are constantly seeing what’s new on the tax floor and that I’m on top of it.
In a tax environment where the laws and regulations are continuously changing and evolving, finding the right tax planning strategies is key to providing clients with the best tax opportunities. We spoke with three tax professionals who offer their most valuable tax planning advice and tips on how to keep planning strategies up-to-date and opportunistic in this ever-changing tax environment.
Paul Fedorkowicz, CPA, is the partner-in-charge at Cherry, Bekaert & Holland L.L.P. (CB&H) in Raleigh, NC, where he provides his expertise in audit and consulting services and advises in strategic planning, process re-engineering, mergers and acquisitions, and initial and secondary stock offerings.
Lawrence A. Hamilton, CPA, is a partner at Hughes Pittman & Gupton, LLP in Raleigh, NC, where he focuses on income tax planning, estate tax planning and business consulting.
Gary M. Remer, CPA, is a shareholder of Maddin, Hauser, Wartell, Roth & Heller, P.C., in Southfield, MI, where he concentrates his practice in the areas of employee benefits, corporate law, taxation and estate planning.
CPA Magazine: Tell us about how you got into tax planning, and what keeps you interested in it?
Fedorkowicz: Cherry, Bekaert & Holland takes the approach that many firms can complete tax return forms competently, but it is the tax planning and consulting services that add extra value to our client relationships and provide customer satisfaction.
Hamilton: After studying taxation at the University of Florida, I began helping people navigate the maze of rules found in our Internal Revenue Code. I enjoy the fact that the laws, regulations and planning strategies constantly change and evolve. Even better, individuals and businesses appreciate legitimate tax planning advice that helps them save or defer taxes.
Remer: My tax planning background actually began from learning the tax collection side as a Revenue Officer with the Internal Revenue Service (IRS). I spent the majority of my time with the IRS auditing qualified retirement plans. The specialty developed continues to be a substantial portion of my practice today. The constantly changing economic environment and the thrill of devising a custom tailored plan for a client keeps me energized on a day-to-day basis.
CPA Magazine: With expiring tax advantages and tax credits, what advice do you offer high net worth clients?
Fedorkowicz: The current advice would be that there probably still is some significant tax legislation to occur before the end of the year, so stay tuned. We are operating in an environment of uncertainty regarding tax rates and other important factors such as estate tax exemptions. Clients with significant opportunities to accelerate or defer income will especially need to undergo year-end tax planning.
Hamilton: Many high net worth clients and their planners are considering accelerating the recognition of capital gains into the 2010 tax year to benefit from the 15 percent long-term capital gains rate. This rate is currently scheduled to increase to 20 percent for the 2011 tax year.
The maximum individual tax rate is scheduled to increase from 35 percent to 39.6 percent. Clients with significant income might consider accelerating compensation into the 2010 tax year to benefit from the current lower income tax rates.
Similarly, high net worth individuals are evaluating whether or not to convert a portion of their regular IRAs to Roth IRAs. With an election, the conversion will be taxed at 2010 tax rates rather than potentially higher tax rates in the future. Individuals with Roth IRAs enjoy tax-free qualified distributions, favorable basis recovery rules and freedom from required minimum distributions prior to the owner’s death.
As the end of the year nears, high net worth individuals and their planners will be monitoring and evaluating any actual or proposed legislative changes to the tax laws.
Remer: My high net worth and entrepreneur clients not only look for tax savings but the deferral of taxes. This is especially true with clients that have excess disposable income that are looking to recover losses they experienced in the financial market over the last several years. Many clients have established defined benefit plans, specifically cash balance pension plans. We often pair a cash balance pension plan with a 401(k)/profit sharing plan containing what is known as a “cross tested” provision. When structured correctly these arrangements allow business owners to receive allocations between $100,000 and $200,000 with employees receiving allocations in the neighborhood of 7% of their wages. By including the 401(k) feature it provides the employees with the most prevalent type of retirement benefit in the market today and is often a draw in recruiting talented staff.
CPA Magazine: In your opinion, when is an LLC the right entity for tax purposes, and when is it not?
Fedorkowicz: There is no simple universal answer as to what is the best entity selection for tax purposes. LLCs are wonderful vehicles for sole proprietorships, rental activities and many partnerships. S corporations tend to be the other major consideration when comparing to an LLC. S corporations tend to be simpler from a tax perspective and seem to offer some potential benefits for saving self-employment taxes; however, legislation to reduce the self-employment tax advantage has been introduced recently.
Hamilton: When achieving pass-through tax treatment is a significant goal, the LLC is a good choice of entity structure. Pass-through treatment allows the profits to be distributed to the owners without incurring double taxation.
However, LLCs may be prohibited from operating certain types of business under state or local laws or professional standards. LLCs may not be the best choice of entity if the organization will be seeking funding from venture capital firms or is planning on issuing a public stock offering.
Remer: Dealing with numerous real estate clients, an LLC is the entity of choice. In addition to the general rule of not holding real estate through a corporation, the LLC provides the flexibility for customized distributions that are not required to follow ownership percentages as well as the potential shifting of losses to specific members. The other advantage and planning tool associated with using LLCs is not in the form of tax planning but in liability protection. The use of a single member, disregarded entity is beneficial to clients by providing a layer of liability protection. It also allows for consolidated reporting of income and expenses by the single owner of the LLC.
CPA Magazine: What tactical planning advice do you offer small business clients, for example: When does it make sense for a small corporation to set up a different entity for equipment and then lease that equipment to the business?
Fedorkowicz: Many of those tactical decisions are driven by entity selection choices. If a business is being operated as an S corporation, it usually makes sense from a tax perspective to create a separate LLC to hold any real estate used by the S corporation as opposed to having the S corporation own and lease it. The tax advantages for separate equipment leasing companies are more limited, but are frequently created for separation of legal liability or when different ownership becomes a priority.
Hamilton: Separating the business from the equipment may be a sound practice for liability purposes. However, when planning to utilize separate entities to hold vehicles or other equipment and lease the assets to a related entity, evaluate any other potential tax ramifications that may arise such as sales tax issues associated with the leases.
Planners also closely monitor and evaluate multi-state activities to avoid any unexpected tax liabilities resulting from activities conducted in other states.
Remer: The two driving issues for many small businesses are taxes as well as liability protection in this litigious environment. Although this may be a tax planning publication the first issue most clients think about with respect to setting up new entities is moving a valuable asset out of their operating business for protection. If the operating business is sued, the assets are protected. These assets may be equipment, real estate and intellectual property. Clients fail to examine the fact that they may have valuable intellectual property such as software that they have developed and patented. Sometimes you need to plan for the worst case scenario to make sure the business can live into the future. No need to worry about tax planning once the business is closed.
CPA Magazine: Comment on effective tax planning strategies, such as cost segregation plans or research and development credits.
Fedorkowicz: Cost segregation studies are a commonly accepted tax savings strategy to accelerate tax deductions on real estate expenditures, be it construction or purchase. The result is to classify portions of a building into smaller segments of personal property. The amounts classified as personal property receive preferred tax treatment including immediate to shorter write-off periods.
Hamilton: Commercial real estate owners can effectively accelerate tax depreciation deductions by properly identifying assets that qualify for MACRS classes of five, seven or 15 years, rather than a class life of 27.5 or 39 years. Depending on the amount of assets reclassified to a shorter class life and the internal rate of return, the savings resulting from the time value of money can be substantial.
The best time to conduct a cost segregation study is near the time of completion of the building; however, cost segregation studies can be performed on newly acquired older buildings. For existing properties, costs that were depreciated over an incorrect life can be reclassified and the tax benefits of the depreciation deductions can be accelerated. This is also an effective strategy for identifying assets eligible for the 50 percent bonus depreciation deduction.
Taxpayers qualifying for the 20 percent research credit may experience significant tax savings. The Small Business Jobs Act of 2010 recently expanded the benefits of the research credit to qualifying small businesses. The credit generally may not exceed the excess of the taxpayer’s net income tax over the greater of the taxpayer’s tentative minimum tax or 25 percent of the taxpayer’s net regular tax liability that exceeds $25,000. Any excess can be carried back one year or forward 20 years. For 2010, the alternative minimum tax is treated as being zero for eligible small businesses, and the carry back period has been extended to five years.
Remer: Because of my background my favorite tax planning technique is really the establishment of sophisticated qualified retirement plans that allow for a current tax deduction to the employer, the deferral of income tax for the participants and a vehicle to allow the entrepreneur to continue maintaining their life style at retirement.
CPA Magazine: Without naming names, tell us about a time when one of your clients made a mistake, such as prepaying property taxes?
Hamilton: Occasionally, a client will have generated a significant amount of income during the taxable year without paying any state taxes on the income during the year. The failure to plan for alternative minimum tax over a two-year time period and to maximize the utilization of the state income tax deduction can cause an excessive amount of tax liability over the two-year period.
We make it a best practice to routinely communicate with our clients over the course of the year, not just during tax season, in order to help them avoid these occurrences.
Remer: Unfortunately clients often have problems, issues and the belief that the IRS is out to get them. Under good circumstances clients come to me before the IRS has identified an issue but other times after the audit letter arrives. Even though this may be the worst of times for the client, it is the most enjoyable part of my job because I love the challenge.
Some of these mistakes have occurred from clients being overly aggressive on their tax returns by trying to deduct 100% of their auto expense on Schedule C because they were taking a deduction for their least expensive European sports car or a physician jeopardizing the tax-exempt status of $10,000,000 worth of assets in a retirement plan by investing those funds in a family member’s real estate venture. The challenge comes in managing a client’s expectations.
CPA Magazine: What prudent advice can you offer small business owners in Sub S corps, for example: What constitutes a reasonable salary when they are making substantial profits and when they are not?
Fedorkowicz: There are many sources of information to get guidelines on the adequacy and reasonableness of compensation. With smaller S corporations, the owners usually have a good sense from the market place on what is a reasonable.
Hamilton: Generally, if an S corporation has accumulated earnings and profits (AEP) the ordering rules provide that any distributions come first from the S corporation accumulated adjustments account (AAA), then from AEP. With the potential increase in the maximum tax rate on qualified dividends from 15 percent to 39.6 percent, planners are evaluating whether to make an election to distribute AEP before distributing its AAA.
Reducing S corporation shareholders’ salaries to save payroll taxes is a common planning strategy. Shareholders’ salaries should be reasonable, based on the services being provided to the corporation. The courts look at a variety of factors to determine the reasonableness of salaries. These factors include the financial condition of the company, the compensation of similarly situated employees in other businesses, the comparison of other employees within the business, and the skills and services the shareholder provides to the business.
At the same time, shareholders expect reasonable profits from capital invested in the S corporation. These profits are paid to the shareholders in the form of distributions rather than wages.
Remer: Before discussing with any client what is reasonable salary, is the client taking a salary? Zero salary is not reasonable as no one works for free. Also, a salary below minimum wage is not reasonable.
Try to look at the number of hours being worked when the profits are low and then figure out a reasonable salary. When profits are high look to see what a comparable officer of a corporation in the same industry is making. With the amount of information on the Internet, this is not such a difficult task. Always remind your clients that the IRS likes to bring up the reasonable compensation issue on audit.
CPA Magazine: What advice can you offer CPAs concerning planning for AMT?
Hamilton: Unexpected results can occur when planning for the AMT. Planners should carefully perform calculations for multiple years and use various alternatives to adequately assess the affect of AMT.
Remer: Perhaps the best advice for any CPA regarding AMT is to warn your clients. With the impact of AMT hitting so many middle-income taxpayers, CPAs need to explain to their clients how AMT works and who may be subject to the sting. Certain common items that give rise to AMT are: large number of personal exemptions; large amount of state taxes; large miscellaneous itemized deductions; large deductible medical expenses; exercising incentive stock options; and large capital gains.
The other piece of advice pertains to discussing whether to hold onto stock immediately after exercising the incentive stock option. The spread between the exercise price and the fair market value is a preference item taxed by AMT. However, if you exercise the option and sell the stock in the same year, you are not subject to AMT. With the volatility in the market, clients are electing to sell the stock immediately out of fear that the value of the stock could decrease.
CPA Magazine: Tell us what software you find helpful in tax planning, and why.
Fedorkowicz: Cherry, Bekaert & Holland generally uses BNA Income Tax Planner software for income tax planning. It is a market leader known for its technical accuracy and its ability to create multiple scenarios, including the ability to work in multiple states. We use various other software products for estate and other financial planning.
Hamilton: We use a variety of software in tax planning. For individual tax planning, we frequently use BNA’s Income Tax Planner and Brentmark’s Estate Planning Tools. For businesses, we have developed Excel spreadsheets to help clients with business plans, tax provisions, carry forward schedules, etc. We also rely heavily on research materials provided by CCH, RIA and BNA.
Remer: The research software used at the firm is known as Checkpoint through Thomson – Tax and Accounting. It provides access to code, regulations and releases from the IRS as well as various treatises and legislative material useful in developing planning techniques.
CPA Magazine: What advice can you offer other CPAs who are interested in tax planning?
Hamilton: CPAs interested in tax planning stay current with the ever-evolving tax rules. The tax laws are regularly being changed by Congress, regulated by the Treasury and interpreted by the courts. In addition to these changes, planners can routinely look for new products and strategies to benefit clients and reduce or minimize their tax burden.
Planners can utilize basic planning strategies such as maximizing retirement plan contributions, encouraging participation in Section 125 plans, using the maximum annual gift exclusions, using the like kind exchange rules and planning for AMT, as well as exploring more complex planning strategies to meet clients’ financial goals.
Remer: The best advice I can offer other CPAs that are interested in tax planning is, to be successful in today’s market, development of an area of expertise is essential.
CPA Magazine: How do you enjoy spending your free time?
Fedorkowicz: Spending time with my wife and our three children.
Hamilton: Traveling and exploring different places and cultures satisfy my adventurous tendencies. Volunteering with civic and community organizations provides opportunities to meet interesting people and help improve the community. I also enjoy spending time with my family and outdoor activities such as tennis, swimming, biking and running.
Remer: When I am away from the office I spend a lot of time with family. For the last several years I have coached my daughters’ soccer teams. I am always looking forward to the family vacations. And the one thing I look forward to everyday is going to the gym for a workout and an hour to decompress.