I would like to highlight an interesting perspective for those who hold within their IRA accounts unregistered securities or investments in limited partnerships such as private equity, venture capital and mezzanine: using an arbitrage strategy.

Let’s begin with a little background:

Investing IRA money in qualified unregistered investments has been within the bounds of IRS rules since 1974 and a common practice among most venture capital and private equity investors. Fast forward to 2010, sprinkle in a little bit of federal government stimulus, and qualified investors can now participate in a once in a lifetime opportunity to create their own personal tax-exempt entities (Roth IRAs) and at the same time arbitrage multiple premises of value.

The Arbitrage:

Let’s say you or someone you know is a high net worth individual who has accumulated unregistered securities within their IRA and these same securities are valued at $3.5 million by the company, its general partner and their outside accountants using United States Generally Accepted Accounting Principle SFAS No. 157 or some other comparable methodology. SFAS No. 157 value, which may not necessarily approximate the IRS’ minority, non-marketable value standards, is only one of many values that a single security can have in the same day. For example, these values may appear as:

-  Control, marketable value $ 6.5 million

-  SFAS No. 157 minority, non-marketable value $ 3.5 million

-  IRS minority, non-marketable value $ 3.0 million

Three distinctive values, same day, same security! This multiple premise of value translates into a permanent taxable income variance of $3.5 million ($6.5 million less $3.0 million) – allowing for a federal and state income tax savings of $1.50 million (assuming an effective 42% tax rate).

The benefit of a Roth IRA, as most people know, is its tax sheltering power over future interest, dividends and capital gains. It is the extra girth of the arbitrage that drastically influences the time value of the tax conversion costs and provides the ultimate wealth accumulating advantage. A time elapse example: under a three year premise that the underlying securities appreciate at a 15.0% CAGR, the arbitrage increases from $3.5 million to $5.3 million. Roth IRAs are a dynastic tax sheltering wealth strategy that will last for untold generations, and what better way to form it but with a little bit of arbitrage.

For those who like hedging arbitrage strategies, here is one for you! Under the new Roth IRA conversion rules there is a special tax incentive for 2010 conversions (ability to equally spread the taxable income on conversion over the following two tax years); and, most importantly, should it appear as if the investment will not succeed, a “fail-safe hedge” provision allows the investor to completely unravel the conversion, at any time, before the tax filing deadline. Under this provision, the earlier transaction can be either abandoned outright or it can be abandoned, reinstituted and re-priced 30 days later at a lower valuation and, therefore, a lower tax conversion costs. This wealth accumulation tactic, which can be further enhanced with a Roth Segregation Strategy, lasts no longer than the IRA/Roth IRA conversion period is open. Only as a result of the Great Recession and only in the United States of America!

While a formal valuation by an independent party is not specifically required within the new provisions, the valuation rulings within the IRS Code and the possible inconsistency between GAAP/IRS valuation methodologies cannot be ignored and, therefore, I recommend that the Roth conversion be made with a tax based securities’ valuation in mind. A well thought out valuation performed by a properly qualified and independent valuator who specializes in complying with IRS security valuations is a conversion cost worth its foundational bearings.

More changes may be on the way for the now infamous FIN 48, the guidelines for reporting uncertain tax positions. For the better part of three years, FIN 48 has seen a series of delays and adjustments that have sometimes had financial departments scrambling to understand the nuances.

A firm deadline for compliance was set last year, calling for all entities to adopt the standard as of the fiscal year beginning after December 31, 2008. However, as we approach the traditional tax season for that period, the IRS is already proposing changes to FIN 48 (for next year at the earliest). FIN 48 has been criticized in the past for its complexity and most notably its lack of clarity when it comes to pass-through and tax-exempt nonprofit entities. Given the deadline, private entities will have to get moving on FIN 48 compliance and stay attuned to the proposed adjustments.

The information reported under FIN 48 is meant to assist in the examination of tax returns by bringing to light areas of interest or magnitude that warrant further inquiry. The IRS is developing a schedule to be filed with corporate returns for taxpayers with assets greater than $10 million, which would require filers to provide a concise description of each uncertain tax position for which they or a related entity has recorded a reserve in financial statements; and the maximum amount of potential federal tax liability attributable to each uncertain tax position.

In addition to positions disclosed by taxpayers under FIN 48, the IRS changes would require that taxpayers disclose positions where no tax reserve was recorded because either it expects to litigate the position or it has determined that the IRS has an administrative practice or precedent not to examine the position.

The IRS proposal asks for descriptions of any uncertain tax positions to contain:

1. The Code sections potentially implicated by the position
2. A description of the taxable year or years to which the position relates
3. A statement that the position involves an item of income, gain, loss, deduction, or credit against tax
4. A statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both
5. A statement whether the position involves a determination of the value of any property or right
6. A statement whether the position involves a computation of basis.

Under the proposal, the IRS would also require that taxpayers indicate for each uncertain tax position the entire amount of federal income tax that would be due if the position were disallowed.

While the changes would not take effect during this filing season, the IRS is looking to expedite the process by requesting public comments by March 29, 2010. At that point, another chapter in the book on FIN 48 will go to press, and CPAs and finance departments will shift gears to keep pace.

Here we are in late January, and we find ourselves between year-end tax planning and the actual filing period for most individuals. CPAs and wealth planners are working together to design an ideal strategy for their clients, and there is a crucial change in 2010 that will have a significant impact on the year: the temporary repeal of the federal estate tax.

Yes, the one-year disappearing act of the federal estate tax has come to pass. Some believe that quick action will be taken to reinstate the taxes at 2009 levels (see below bullets for details). Others believe Congress will proceed cautiously in an attempt to enact more sweeping reforms. In either case, any reinstated tax may or may not be made retroactive to January 1, 2010.

Needless to say, planning under these circumstances is challenging. Indeed, the failure of Congress to either extend the 2009 estate tax rules into 2010 or enact a permanent estate tax law has created a slew of unfortunate consequences. Some important pieces of the puzzle are:

- Both the federal estate tax and the federal generation-skipping transfer tax (a separate tax on property given to grandchildren, great-grandchildren, etc.) are repealed for 2010 unless Congress enacts legislation to reinstate them, retroactive to January 1, 2010 or otherwise.

- Both taxes are scheduled to return in 2011 at levels that applied prior to 2001. That means a $1 million exemption and a top tax rate of 55% (in 2009, the exemption was $3.5 million and the top rate was 45%).

- The federal gift tax remains in effect with a $1 million lifetime exemption, and the top tax rate has dropped to 35% in 2010 (versus 45% in 2009).  However, at this point in time the maximum gift tax rate is scheduled to jump to 55% in 2011.

Along with the repeal of the federal estate tax come new rules for determining the federal income tax basis of inherited assets which, if not changed, could mean heirs will pay more capital gains tax.  (more…)