Tax Planning Opportunities During a Market Decline

Investors in the global marketplace likely experienced declines in their portfolios at the close of 2015 and early during 2016.

While understandably making investors nervous, a downturn in the economy may pose considerable tax planning opportunities, for both income and transfer tax purposes. The following are just some of the strategies that can take advantage of a down market.

Convert a Traditional IRA to a Roth IRA

Taxpayers that have a traditional individual retirement account (IRA) may find that a bear market is the best time to convert those tax deferred assets to a designated Roth IRA. The advantages of the Roth IRA over a traditional IRA are that qualified distributions from the Roth are tax-free, there are no minimum required distribution requirements and if the account holder dies before exhausting the account distributions to beneficiaries remain income tax free.

At conversion, the taxpayer will pay ordinary income tax on the market value of those converted assets.However, depressed market values of the assets held in a traditional IRA will yield a lower tax bill than if the same conversion were to occur for the same assets during an up market. The resulting benefit is that the taxpayer has minimized the tax liability thanks to lower market values while also moving the assets into a tax advantaged account where they will hopefully appreciate in the future.

Exercise Nonqualified Stock Options

Many employers offer key employees stock options as an additional benefit to their regular compensation. One of the most common form of options granted are nonqualified stock options (NSOs). A NSO is an option to buy company stock at a price less than its fair market value when the option is exercised. The spread between that purchase price and fair market value is included in taxable income in the year the option is exercised and reported via the employee’s W-2. If the stock is currently at a low valuation due to poor market conditions but the employee expects the value to appreciate in the long-term, it may be worth considering exercising those options now. The result would be a smaller current income tax bill with the expectation of future growth and capital gains treatments if the stock is then sold.

Consider the following example where a taxpayer holds a NSO to buy company stock for $20 per share with an expectation to exercise the option and hold the stock until its fair market value reaches $40 per share, at which point the taxpayer will sell the stock. If the taxpayer exercises the option after a market decrease when its fair market value is down to $25, the taxpayer will report $5 per share of current ordinary income. If the taxpayer holds the stock for a long-term period and sells at $40 per share, the $15 per share gain will be taxed at favorable long-term capital gain rates. If the taxpayer had waiting until the price recovered to say, $35 per share before exercising the option, then $15 per share would be taxed as ordinary income currently and only $5 would receive favorable capital gains tax rates.

Gift Assets at a Reduced Transfer Tax Cost

The general rule is it’s better to gift an asset at a lower value than a higher value. With the value of the gifted asset being lower than it would in an up market, a transfer tax opportunity exists to move more wealth out of a high-net-worth individual’s estate at a lower transfer tax cost. This could mean moving more shares of a stock with promising long-term appreciation prospects while not exceeding the annual exclusion limit. It could also mean having to utilize less of a taxpayer’s unified estate and gift tax credit than in stronger economic environment as well. This simple but effective transaction can yield significant long-term tax benefits, particularly if done in the multi-generational context.

It should however be noted that it is generally not advisable to gift an asset outright if its basis is higher than its fair market value as that potential loss cannot transfer to the donee. In such a circumstance, the donor should either gift a different asset, or sell that asset, recognize the loss, and then gift the cash. The donee can then repurchase that asset.

One way taxpayers can leverage this concept, particularly if they have used all their gift tax exemption, is through the use of a Grantor Retained Annuity Trust (GRAT).  A GRAT can take advantage of the current economic environment by combining the benefits of a low Sec. 7520 interest rate and the potential for future appreciation of assets.

In this transaction, an asset is transferred irrevocably into a trust which will pay an annuity to the grantor for a term of years. Because the present interest value of the annuity is equal to 100% of the asset value plus that Sec. 7520 rate, there is little to no gift tax ramifications on the transfer. If the asset appreciates at a rate exceeding the Sec. 7520 rate (1.8% in June) and the grantor outlives the trust term, that appreciation is successfully transferred at little to no gift tax cost. Since the annuity payments are based on the asset value as of the transfer, depressed market values can make it more likely for the GRAT to be successful.

While most investors would agree that a market downturn that would not be classified as a positive event, such a downturn is not without its opportunities. Depressed values can allow for potentially significant income and transfer tax savings and taxpayers should look to take advantage of these opportunities.