An Advanced (and Unique) Investment and Tax Solution

Most advisors recommend taking a long-term approach to money management and investments. As a group, they tend to leave the active trading decisions to professional money managers via separately managed accounts, mutual funds, etc. Many are specialists in modern portfolio theory and asset allocation strategies and with good reason. Investment success is more likely for most of us when we take this approach. No one has the ability to be right consistently via market timing and trading activity. Investments don’t always move in the direction one thinks or hopes they will. Thus it is more common to find advisors who create asset allocation models, and select mutual funds or other investment products to fill the various asset classes within a desired portfolio.

The last two years taught advisors that despite all their discussions with clients about long-term performance expectations, individual investors can and will make short-term emotional decisions about their money. Over the five quarters ending March 31, 2009, long-term equity mutual funds experienced a net outflow of $410 billion (Investment Company Institute, “Worldwide Mutual Fund Assets and Flows,” January 27, 2010). This kind of outflow and redemption activity wreaked havoc on fund managers who were also dealing with a very difficult investment environment at that time. Managers were often forced to liquidate positions at deep losses or sell into illiquid and declining markets. A PIF, with its specified investment term or time horizon, is one solution for both the client and advisor.

At first glance it may seem a drawback to commit funds for a certain period of time. But for an investor with a longer time horizon (typical timeframes are three to five years), investing alongside other committed investors for mutual gain and profit can be very attractive. Anyone who has ever put funds into a retirement account, or purchased an annuity, long-term CD, private REIT and other similar holdings has already shown a propensity for and comfort with long-term holdings.

[Read an example of how to use PIFs.]

Money managers generally prefer closed-end type funds over daily liquidity funds. They love not having to deal with constant fluctuations in assets and cash flows. And since PIFs typically have fixed terms such as three, four or five years, the manager knows that the account is “sticky.” This structure allows them to take a true investment management approach without worrying about cash reserves for redemptions and being forced to buy or sell at a bad time. If capital gains are generated, even in an otherwise down year, the fund has the option of making a cash distribution to investors to cover the tax bill or recognizing losses to offset the gains.

PIFs are generally limited partnership or limited liability company structures adhering to partnership taxation status. They are private placement investments under the SEC rules and thus are generally only available to accredited investors with relatively high account minimums ($100,000-$1 million is typical).

TWICE THE VALUE

By definition, PIFs are not traded publicly on an exchange and do not have readily ascertainable quotations of value or prices per unit. Thus the funds must be appraised regularly in order to determine the fair market value (FMV) of the interests owned by investors. PIFs actually have two different values at any given time including FMV and net asset value (NAV). NAV is fairly straightforward and simply measures the total value of the underlying portfolio divided by the total units outstanding. FMV takes into account a variety of factors based on the fact that investors hold an illiquid minority interest in a private fund that is not readily marketable on an open exchange. It is common for appraisers to apply valuation adjustments (discounts) when valuing such an asset. Depending on circumstances, a typical adjustment may be 25%-35% from the fund’s NAV.

FMV is important as it is the value required to be used for all tax reporting purposes. Any taxable transaction involving the PIF units owned by an investor must be reported as the accurate FMV as required by the tax code. These include gifts, estate valuations, transfers to charitable lead trusts (CLTs), transfers to grantor retained annuity trusts (GRATs), installment sales or gifts to intentionally defective grantor trusts (IDGTs), Traditional to Roth IRA conversions, Traditional IRA required minimum distributions (RMDs), and many more. And therein lay the tax advantages that may be gained by investors holding PIF interests.

One example of a benefit from a reduced FMV is in the arena of intra-family sale transactions. For example, a couple owns a PIF interest with $1 million NAV and $700,000 FMV. The PIF has a five-year time horizon. They can sell the PIF interest to their son at full FMV of $700,000. In a simplified scenario, the couple takes back a promissory note from the son in the amount of $700,000. The note could be structured as interest-only with a balloon payment in five years and would use today’s very low applicable federal rates (AFRs) to determine the interest rate. The current (August 2010) mid-term AFR is 2.18%. Since the PIF has a five-year term, it will cash out at full NAV just in time to make the balloon payment on the note. Assuming no growth on the PIF interest over the five-year-term, the NAV would be $1 million. The son pays off the note with $700,000 and retains the remaining $300,000. In this scenario, the parents have essentially made a $300,000 tax-free gift to their son and removed this asset, and all future appreciation from it, out of their estate.

PIFs can offer an array of unique investment solutions to clients anytime a specific investment objective and similar time horizon are shared by a certain group of clients. The arbitrage opportunities between NAV and FMV offer unique and substantial tax saving opportunities as well. Note that the setup and maintenance of PIFs can be very difficult and is subject to multiple rules, regulations, jurisdictions, restrictions, etc.

Proactive advisors must be able to bring advanced solutions such as private investment funds to their clients and prospects. PIFs are also an excellent opportunity for advisors to work with their center of influence referral sources such as CPAs and attorneys to bring this advanced solution to a wider audience and gain more assets under management.

Joe Luby is founder and manager of Jagen(TM) Investments LLC, headquartered in Henderson, Nev. Luby may be reached at 702-451-3456 or [email protected], or by visiting www.jagenfunds.com.