Money Talk

Episode 41

Transfer Taxes, Investing

Today’s subject is all about nothing.Before we get into the details of whatever they may be, I’d like to put in perspective these transfer taxes, the estate and gift taxes; federal and sometimes state. In the year 2018, the total taxes received in respect of these transfers was 23 billion, which is three-quarters of 1% of the total $3 trillion in tax revenues.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck LeFebvre: This is Chuck.

Ed Sutkowski: This is Ed. Today’s subject is all about nothing.

Chuck: Well, isn’t that really– We could just rename the whole podcast.

Ed: Yes. Before we get into the details of whatever they may be, I’d like to put in perspective these transfer taxes, the estate and gift taxes; federal and sometimes state. In the year 2018, the total taxes received in respect of these transfers was 23 billion, which is three-quarters of 1% of the total $3 trillion in tax revenues.

Chuck: To put that in further perspective- so you said, what, 18 billion?

Ed: No, well, it’s 3 trillion is the total, and the transfer taxes are 23 billion or three-quarters of 1% of the revenue.

Chuck: 23 billion is a really small amount in the federal budget. I just learned about a week ago that apparently, the Treasury estimates that a trillion dollars- that with the so-called tax gap is a trillion dollars, that tax gap referring to the difference between the revenue that should be collected based on strict application of the revenue code and the tax that is collected. You’re talking about something that is a fraction of– It’s 2% of the tax gap, right?

Ed: It’s crazy. It’s crazy.

Chuck: 0.2%.

Ed: Yet you have this whole industry of guys and gals like us, I hate to be critical of what we’re doing, but there are all kinds of tools available to pay what is otherwise a voluntary tax.

Chuck: It’s really quite a remarkable thing that we have this gigantic infrastructure in place for something that doesn’t really move the dial-

Ed: At all.

Chuck: -On revenue. What it is, what it was originally designed to be at least, was a type of social engineering in the sense of- the FDR’s speech about- or I guess it was Theodore Roosevelt about the trust-busting, and we’re going to eliminate these dynasties that get passed down from generation to generation, and that’s what the tax was designed to do, rather than be a revenue raiser. I’m not sure how I would score its success.

Ed: I’d score it as a negative. The net costs of professional involvement and the staffing at the IRS level, it’s a negative, and it is a crippling impact– It cripples economic rewards. You’re spending time on something that’s not worthwhile, it doesn’t create value. You’re not making a change. All you’re trying to do is Elizabeth Warren’s approach, “Let’s take the money from those that have it and give it to those who do not have it,” except that when you go from the person to the government, and finally giving it to the recipients, guess what happens?

Chuck: It doesn’t– That third step seems to be a long time waiting.

Ed: The infrastructure that’s built up to service this gigantic attempt to- let’s equalize not only opportunities but results, we can give money to– Anyway, I don’t want to get into that.

Chuck: Well, I do think that the question is, if you buy into the notion that the goal is a laudable one, has it achieved that goal? I don’t think it has. In the meantime, it has to be one of the most complicated and expensive taxes for the IRS to administer and it certainly is one of the most complicated and expensive taxes for individuals to plan around, and for most people who pay the tax, the preparation of that estate tax return is probably the most expensive individual tax return that’s prepared for them during their entire existence.

Ed: Oh, this is a snapshot of the balance sheet of the descendants day of death.

Chuck: Right.

Ed: It’s not cash, but almost an accrual basis account. In any event, the focus I’d like to address a little bit is the estate income taxes and transfer taxes. Let’s just talk about Illinois. Assuming we have an exclusion, this year, it’s 11.7, and next year, it’s 12,060,000. At 11.7, a single person resides in Illinois, guess what their tax is?

Chuck: The Illinois tax? I’m going to just off the top of my head guess somewhere around $600,000.

Ed: $1,140,000.

Chuck: I was way off.

Ed: I just looked at the website, 11.7, $1,140,000.

Chuck: Yes, I guess that doesn’t surprise me at all.

Ed: Why would you die a resident of Illinois?

Chuck: Most people really don’t plan on dying, period, right?

Ed: Yes. Let’s go through that. The Illinois tax is imposed on the sum of your lifetime what are called taxable gifts, plus $4 million. You can get caught up. There was $4,300,000. It was right over 4 million, about a $40,000 tax.

Chuck: Right.

Ed: Probably about $40,000 to administer.

Chuck: Probably, yes. The Illinois estate tax is really a very complicated tax for people to understand because the rates, the effective rate slides all over the place because there’s actually two different tax rates that apply. You have to calculate both and then apply the one that results in the least possible tax. The base that you use to calculate the rate is different for the two rates that you have to apply. People just completely don’t understand how that tax works.

Ed: Chuck, I don’t mean to interrupt you, but so what? Get out of Dodge.

Chuck: You’ve seen this too where people leave the state of Illinois because they want to avoid that tax, but they leave their property in Illinois, so they still end up paying the tax.

Ed: That’s because they haven’t secured some interesting opportunities to avoid that. The bottom line, there are several states that are best for no income gift to estate or inheritance taxes. They are Florida, Nevada, South Dakota, Texas, Tennessee, and Wyoming.

Chuck: You left out Alaska. They actually pay you to live in Alaska.

Ed: It has a bit of an income tax, I believe.

Chuck: Okay.

Ed: This is one with no income, gift, estate, or inheritance taxes. Now, a lot of these folks have a lot of property taxes and a lot of sales taxes, but if you’re focused just on those- I call them accumulation and transmission taxes, you have to have rocks in your head, your surviving spouse, assuming you’re married, die a resident of Illinois, one of the tax states. Iowa was terrible. Having said that, I think that the point may be, look, this tax and the whole scheme of things from the governance perspective is 1/2 of three-quarter percent. It’s almost nothing. Yet, we’re spending a three– I’m sorry, three-quarters of 1%. It is silly. Now, Chuck, the idea is we have people receiving this money. What is the problem that you see more frequent than that with someone receiving money?

Chuck: They’re not accustomed to having it. They don’t really know– Sometimes they think it feels like they’re receiving less than they do, so they continue to experience personal economic anxiety that they don’t really need to feel because they should feel more secure than they do. It hasn’t really conferred in a sense a psychological benefit on someone who can’t really appreciate the nature of what they’ve received and essentially continue to have the same level of anxiety that they did before. The flip side is people who believe that whatever they’ve received is more lasting or can be spent more fluidly than it really can if you want to preserve it. They burn through it right away.

Ed: Yes. The second generation, not to castigate the second generation, but if the second generation has not been schooled, has not been addressing periodically, what’s the stock, what’s the bond, how these things work, they then rely upon this advisor, whether a lawyer, accountant, investment advisor, a warm advisor, and who doesn’t always have the individual’s best interest in mind. We see situations where one– I can’t believe X dollars– 200 issues-

Chuck: Isn’t that amazing?

Ed: In a portfolio. Some was fixed, some mutual funds, but 200 issues. The management fee was 1.4%. Getting back to– Forgetting about my favorite hobby horse for a second is how should these assets be handled? Let’s assume I have a million dollars and I’m a single person. My spouse is a ghost. I have three children of various financial attributes. Do I give them the assets outright or in trust? Your experience, Chuck?

Chuck: I’ve seen it many ways, and of course, it depends an awful lot on the nature of the person who’s receiving it, and of course, the amount and the nature of what’s being given. What I find is that quite frequently when parents are doing planning for the benefit of their children, this isn’t always the case, but they typically will be concerned that their children are not going to be able to properly manage the assets. They tend to keep them in trust and they especially tend to keep them in trust. If during the conversation you happen to mention that, if there is a divorce down the road, that assets that are held in the trust can’t be separated by a court and allocated out in a divorce, and boy, my perception is that most parents think that their kids probably don’t manage money very well and are doomed to get divorced sometime following their death, and they want to protect them from those two things. The way they protect them is by holding the money in trust.

Ed: As they’d have a third party, hopefully, skilled with financial and accounting matters.

Chuck: That’s the Pandora’s box that they open when they go down this path is then, well, you’ve addressed one problem, but you’ve created a different concern here which is that someone still has to be a trustee and manage those assets and understand how the trust is administered, what the legal requirements are in order to administer it properly, and how to keep proper accounting of that trust. That really can be a thorny issue on its own.

Ed: Let’s talk about that. A trust, what does that mean? Well, there’s a standard that the trustee, the independent third party, who has no skin of the game, is managing the assets and making distributions, making sure returns are filed and the line. Separate to a standard, let’s talk about, first, the absence of a standard. You can simply say to a trustee, “Here’s the cash, here’s the money, do what you want,” so to speak, assuming you’ve got the right trustee. Then you can go to another form, which is barely a dollar amount to be distributed to the beneficiary every year without regard to need. Then in the interim, right in the middle, you can have one- the trustee is to pay whatever’s necessary for the reasonable support, comfort, and education. We can have a lot of arguments about that. The alternative is, “Well, we’re going to give you, Mr. and Mrs. Beneficiary, 5% of the value of the trust every year. No discretion.” It’s like getting a deposit in your bank account, but do you want to cut back if there’s divorce, if there’s accreditor issues, and the like? The design of that standard is where the judgment comes in. Chuck, you headed up a trust department for more than a few years, and your experience on that wide range from no discretion to all kinds of discretion.

Chuck: My experience is that the vast majority of the trust that are written have some version of what would be referred to as an ascertainable standard which is a tax term, basically meaning that at least in the eyes of the IRS, the directions about distributions are sufficiently tangible that they can be enforced in court, and in other words, it’s ascertainable whether a particular distribution is proper or improper. It’s not just wholly up to the discretion of the trustee, and the most typical language used is health education, maintenance, and support which is a pretty open-ended way of describing things.

Ed: Reasonable. What’s reasonable to you and what’s– Someone with 100,000 and someone with 100 million, what’s reasonable?

Chuck: That actually has been- because that’s a very commonly used language, that actually has been the subject of enough court cases that you can look at court cases and start learning a little bit more about what courts think that means. What they generally mean is that what’s reasonable is it there’s an anchor point on that, and that has something to do with the lifestyle that the person was accustomed to prior to the trustee-

Ed: Versus after.

Chuck: Versus after. What happens is that language is used frequently, that means the courts are most familiar with it. It also means that if the trustee is an institution or some professional trustee that administers a lot of trust, they are also most familiar with that particular language. There’s this universe that’s grown up around the use of that language, but I can tell you from having been involved in the administration of a trust by an institution that there’s a rule of thumb which is that you shoot for, first of all, the net income, but for the grand total of distributions, try to not exceed 4% per year. 4% of the value of the trust estate per year with the idea being that, again, just as a general rule of thumb, that you can distribute 4% of the value of a trust estate annually, and still expect to pay a healthy fee to the trustee and to accountants, pay taxes, and have what remains in the trust estate grow at roughly the same rate of inflation.

Ed: You assume a 6.5% rate of return which is not uncommon if you were in stocks over the last X number of years, so you’re lopping off one and a half percent.

Chuck: One of the things that happens is these institutional trustees are typically not willing to let the entire portfolio be invested in stocks. They’re getting a lower overall net return than the 6.5% that you quoted because any kind of trust where there’s distributions coming out regularly, their investment people will almost always insist, this is something I frankly don’t agree with, and I know you don’t, but their investment people will almost always insist that there has to be some kind of an allocation of 30% of that or 40% of that to fixed income securities. That can really erode the total return quite a bit.

Ed: Yes, you’re preaching to the choir here. The theory is 100% invested all the time, and leave it alone, good stocks, x funds, total return, but we’ll not get to that. We’ve talked about that so many times, I’m confident people want to run over me as I walk around. Having said that, we can also- Chuck, I want to emphasize the idea about the standard. I’ve seen some situations where the individual, the father wants to alter the- not the destination, but the actions of the child. I’m going to say to Peter, “Look, Peter, you are going to get an amount equal to 100% of your W2. So, you’re going to get a job. If you have a job, we’re going to give you double it.” Has that ever worked?

Chuck: First of all, I’m hard-pressed to think of an example where I’ve seen someone really try that and put it in place.

Ed: Chuck, I have. Guess what?

Chuck: It doesn’t work?

Ed: It doesn’t work.

Chuck: I think that it’s a bit of a fool’s errand to– My grandmother, she was someone who didn’t want us to– She didn’t want to have a funeral. She told us when she was getting older, she didn’t want a funeral, and she certainly didn’t want a visitation. She said, “Look, if someone’s not going to come visit me during my lifetime, they better not show up after I’m dead.” I feel the same way about stuff like this. If you’re concerned, if you are trying to control the way your son or daughter lives his or her life and you’re not successful doing that during your lifetime, you’re not going to be successful doing that after you die.

Ed: Right, except I know this story, this gentleman passed with no descendants, but a lot of friends. The instruction was to be buried at the cemetery, like 100 miles from his residence. The representative of the estate was to give whomever showed up at the burial and stayed through the whole proceeding at 10,000 bucks.

Chuck: Well, then those are the people who cared.

Ed: That’s exactly right. I thought it was very imaginative.

Chuck: It is.

Ed: The issue we were talking about, any number of folks that we deal with enjoy the accumulation process, but I’ve had so many sit in our conference room say, “You know, accumulating it is a lot of fun, but giving it away is a pain in the ass.”

Chuck: The reason for that is because there is a pervasive sentiment among a lot of the clients that I’ve worked with. I think you too, you also, that they’re worried, especially people who started from nothing or very little and then built up a fair amount of wealth, they feel like that was a character-building process and they are worried that they are going to deny that process to the people that they pass their wealth onto.

Ed: Chuck, you hit it. The journey of those that have accumulated wealth, and I’m not talking about a gazillion dollars, it could be 100,000, it could be 200,000, whatever it is, the accumulator wants to make sure that the beneficiaries enjoy the journey.

Chuck: I think the thing that I’ve noticed, and tell me if you disagree with this, but the thing that I’ve noticed is that sometimes they are absolutely right, that it is just a terrible thing for this money to fall into the hands of their descendants who waste it, mismanagement. The phrase is “born on third base, thought he had hit a triple” and having received the inheritance, spend the rest of their lives being obnoxious and turning everyone away from them because they adopt that attitude. That happens in some of the cases. In other cases, it really doesn’t. The difference is not how you’ve structured your estate plan. The difference is how you have raised these children from the beginning.

Ed: That is the– Chuck-

Chuck: By the time you’re in the lawyer’s office, post-retirement age typically, doing this planning and worrying about this stuff, you’ve already set that mold. There’s probably an answer. You may not be aware of what the answer is, but what’s going to happen is preordained at that point.

Ed: Yes. You cannot change the color of the eyes of the child, the grandchild, the great-grandchildren. People like to build buildings or name buildings or scholarships. They live forever. The reality of it is you’re going to live through the eyes and ears of your descendants, if you have descendants, if not, through others. The accumulations process is fun, but if you think you’re going to change the color of the eyes of the beneficiary, you’re wrong, doesn’t happen.

Chuck: It’s taken a little bit of time that now people listening might think, “Well, what Ed and Chuck are saying is pretty obvious.” It’s taken a little bit of time for it to dawn on me, at least. Maybe that says something about me, but–

Ed: No. You know what it says, it says that you’re not 80 years old. You have to have lived these experiences. The textbooks don’t get it because they all talk about the taxes. 2041– All these devices you can do– But you don’t want to address this. What’s the reality of it? The client invariably- you ask your client, “What are your concerns? What are your fears?” Two, three hours later, you can’t find out except they’re right at the door to leave, “And Ed, by the way, this is what I really want.” “Well, why didn’t you tell me this?” I’m almost saying that you’re a fool to accumulate assets, it’s almost silly.

Chuck: Well, and I think this is why people end up falling back on that, what I was referring to before as the standard language, this health, maintenance, support, and education language that you see in these trust agreements. I think the idea is that people punt. They say, “Well, I’m not sure how I want to regulate the way these things are- these assets are going to be distributed out. The trustees are going to have to be observant and use good judgment.” Then the lawyer says, “Well, this is the standard language. That’s the language that ends up in the document.”

I think people can expect that there was going to be a lot of flexibility in the way that actually gets administered as their children and further descendants go through life. Like you said before, if there’s a divorce, then you do X and if something else happens, you do Y. My observation is that, and maybe this is a subject we’ll want to talk about in some future podcasts at some length, is that it’s pretty hard to find a trustee that really is going to execute that in the manner that people might have in mind. Isn’t that your observation?

Ed: There’s two parts to the answer. I see it. One is the unit trust is 5%, greater than the income of 5% or 6.5%, whatever you think is going to happen to the market, if you invest in stocks, which I am, but a limited portfolio, and the idea is I know it’s going to go up 6.5%. I would built-in to the descendant a unit trust amount of 6.5% of the value as of December 31 of the year and you pay out that percentage throughout the balance of the other next year. That’s one; the uni trust percentage of the value of the assets with no discretion like a Social Security check.

Chuck: Which by the way, that is really my favorite structure for reigning in a spendthrift in the sense that people will often use this health, education, maintenance, support language when they have a beneficiary who’s a spendthrift and they expect the trustee to hold the line.

Ed: Be the cop.

Chuck: Right. This is where my experience probably does inform this situation a little bit, which is that those beneficiaries who are spendthrift, they can always create a crisis that the trustee then has to dip into the trust and rescue them from.

Ed: The litigation if they’re not, the surcharges, it’s a lawyer’s dream.

Chuck: If you just have a trust that there’s essentially no discretion, you’re going to get 5% per year or 6% per year, then guess what? Whatever sob story the beneficiary comes to the trustee with, it’s, “Well, I don’t have any discretion here. This is your check,” and on the flip side, if the beneficiary just blows that money-

Ed: So what?

Chuck: -the trust is still there.

Ed: The other side of this that I find fascinating is getting in a position that the beneficiary receives an amount that allows the beneficiary to pursue the beneficiary’s passion but not to do nothing. It’s a theoretical area of interest to me, but I had no answer. The idea is maybe this 5% depending upon the amount involved, and you can have multiple children, multiple trusts, and grandchildren, you can do all sorts of things in terms of the tools to achieve that objective. You do not make it easy for the child- I’m saying child, the beneficiary to do nothing, yet to encourage the beneficiary to do something, the passion, but yet not be insolvent.

Chuck: Right, but some of them simply don’t have a passion, right?

Ed: That’s a whole different topic, this question of passion. Academic excellence doesn’t suggest passion. There’s almost an inverse relationship, I hate to say this, for those that are number one in their licensed professional class, that are economic failures. The correlation, the absence of– Direct correlation. Super student, terrible investor, is that fair?

Chuck: Oh, I’ve seen that, and I think we see that a lot with licensed professionals who start out as good students. Then they go to a professional school and they graduate and they become lawyers or accountants or doctors. There’s no question that they’re very intelligent people, but quite often, they do not manage money well at all. Not that they don’t manage cash flow quite often very well, but even the ones who do, end up investing some amount of their earnings very frequently, end up being the victims of predatory “advisors”.

Ed: I’ll give you an example. An electrical engineer, a guru, just really, really bright guy. Looking at his portfolio and his objectives and concerns. I have this annuity and there’s no fee. I said, “There’s no fee.” “What do you mean? It’s a commercial annuity, right?” “Yes. Well, The broker told me that the company pays the fee.” I said, “What?” I think this discussion is not going the right way. I could never, never tell him that you’re sandbagged, is the case.

Chuck: Right. Out of the goodness of their heart, they just decided they’re going to tap into profits made from other lines of business, and pay the fee for your annuity.

Ed: “Trust me, I’m your friend.” That’s why you see that our favorite topic is the percentage charged. If it’s advertised, don’t eat it. If you’re talking about managing your money, don’t go there because they want 1%, 1.4%, or whatever. They’re not in this business to not make money.

Chuck: Right, exactly.

Ed: The idea is, can you come up with a solution without their help?

Chuck: Some people can’t. That’s the bottom line.

Ed: Yes. If you want a warm advisor, you’re going to get a warm advisor, but the question is, what’s the cost?

Chuck: Right, yes. There’s always a cost.

Ed: Yes, what is that cost? Is it reasonable? That’s for another– Well, we’re beating this dead horse. We’re not going to change it.

Chuck: That’s for our previous 30 podcasts to discuss.

Ed: The point is you have to determine the needs, not the expectations but the concerns and fears of the subject. What are you trying to do here and why are you doing it?

Chuck: Right. Yes, I’ve observed that people- if what you want is for your children or your grandchildren to thrive, whatever that means from one person to another, and you’re trying to do that by giving them some economic benefit, what I observed is that people don’t necessarily- it depends from person to person, but people don’t necessarily need to have a lot of material luxury in order to thrive, but what they do need is they need to feel confident that I can go out there and I can take a risk. I know that if it doesn’t work out, I’m going to land on my feet.

That is a different thing than simply making sure that everything is paid for all the time. It varies from- and for some people, the only way they can feel that way is if they’ve got a constant stream of money that’s actually passing through their hands.

Ed: The idea is, pursue your passion. I don’t care what it is, whether it’s loading bricks, whether it’s making bricks, whatever, but I’m going to help you, so you can do that. I’m not going to allow you to not do that. That balance is very difficult-

Chuck: Very difficult. Yes.

Ed: -if ever attained. I must tell you, this sounds silly, but I’m not sure either of us create value.

Chuck:  On this particular podcast, we might have talked a lot of clients out of our services.

Ed: That’s right, but that’s okay. The idea is, understand the provider of the service, what are the nature of the services that can be provided? I can’t change the color of your child’s eyes. If you think I can, guess what? I can’t, but I’ll charge you $500 to be able to tell you that, but that’s for the next topic. I don’t know. Maybe I’m overly pessimistic about the sort of thing, but value can be a disease.

Chuck: True.

Ed: It can stifle creativity. The journey is what it’s all about, not the destination.

Chuck: I think that that would be my takeaway here, which is that for people who are in that accumulation phase, don’t put off those moments with your children, your grandchildren for later as part of your estate plan. That has to be part of the project you’re working on right now because later they will have already formed, right?

Ed: Yes.

Chuck: Then you’re going to be in our offices talking about, “Okay, how can I control them from the grave?” We’re going to be saying, “We can help you save tax. We’re good at that.”

Ed: “That’s our game.”

Chuck: “We’re not so good at changing fully formed adults into different people than what you’d hoped were going to turn out.”

Ed: I’ve always asked folks, “Tell me what did you feel passionate about when you were a kid, you were an adolescent?” The answer will tell me what they’re doing now.

Chuck: Interesting.

Ed: Then I ask them, “What will you be concerned about five years from now? What about 10 years from now? What about 15 years from now?” All designed to figure out what is this folk, this client, this person about? Oftentimes the solution is no solution. You’re fine. Let it go by intestate succession or by joint tenancy or via an insurance policy. You don’t need me. With that, I think I’m going to file for bankruptcy. We got rid of all clients.

Chuck: There we go. That’s right.

Ed: Remember you can’t take it with you, but I’m trying.

Chuck: There you go, and many people do.

Ed: Thanks.

Chuck: Great.

Ed: Nice to see you.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.

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