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How the Experts Break Out Of Gridlock

People who are stuck in traffic get impatient. When caught in legislative gridlock, the temptation to take a shortcut across the median is too strong for some to resist. This explains why tax officials are resorting to scare tactics to make policy changes that the Clinton administration has no prayer of getting through Congress. It’s the newest thing in democracy: legislation by announcement.

Want to get in on the game? With a little know-how and a stack of blank IRS stationery you, too, can reshape America’s, financial affairs. Here is how the experts do it.

Apply blindfold, offer last meal, start the trial. Instead of selling highly appreciated stocks and triggering large capital gains taxes, the law lets investors borrow and sell identical shares from a broker or third party. This “short sale against the box” locks in the shareholder’s gain while it defers the tax, perhaps indefinitely. In fact, if the shareholder is savvy enough to die while the short sale is still in place, the capital gain can be completely avoided through the “step-up” of investment assets at death. Democratic Party leaders detest these rules, especially the basis step-up.

Treasury solution: Announce a legislative proposal that would trigger the shareholder’s gain — but not a loss — when the offsetting short sale takes place. Make the rule retroactive to cover transactions that take place any time after the proposal is made, and even those dating back before the change was proposed if the short sale remains open at enactment. Result: Unlikely though passage may be, prudent investors will have to treat your proposal as if it were law for as long as it remains on the table, or else risk triggering massive unanticipated taxes.

Be distracted by neither the facts nor the law. As our Page 1 story on split-dollar life insurance points out, you can issue a technical release that recites all the relevant legal standards and then proceed to a conclusion that has no support from those standards whatsoever. How you get to your conclusion is not the point. What matters is that once taxpayers see that you plan to give them a bellyache, most will avoid you the way kindergartners avoid brussels sprouts. As for those who insist on doing what the law permits, well, you can get a handle on the subtleties later.

Make a proposal, then unplug the phone. Well-to-do taxpayers can use a “Qualified Personal Residence Trust” to give a house to their children or other heirs at greatly reduced tax cost. Some taxpayers went a step further by eventually buying the house back from the trust, allowing the heirs to receive cash instead. Why bother? Because the heirs receive the same value, while returning the house to the hands of an older family member allows the house to receive a stepped-up basis when the older relative dies, saving more taxes down the line. (That nasty basis step-up rule again!)

Treasury solution: Issue proposed regulations requiring any such trust established after May 16, 1996 (a month after the regulations were announced) to prohibit the repurchase of the house by the original owner. Regulations can stay in the proposal stage for years. In the event the proposal is eventually withdrawn or struck down, you have still coerced everyone who created such a trust in the interim to swear off the transaction you do not like. An additional wrinkle is that the proposed regulations warn creators of older trusts that if they proceed with such a repurchase, the tax folks may attack using “established legal doctrines.” Do not worry about why, if “established legal doctrines” cover the situation, your proposed regulations are needed in the first place.

Affix a sexy label. Lest the change in policy on Qualified Personal Residence Trusts be seen as an attempt by non-legislators to legislate, Treasury cloaked its proposal as a “clarification” of existing rules. What was being clarified? That the existing rules prohibit, in the Administration’s words, “bait-and-switch” tactics in these residence trusts. “Bait-and-switch” is nasty, deceptive, even illegal in many contexts. Never mind that nobody is actually being baited or switched; the younger beneficiaries of these trusts get exactly the same economic value as if they had acquired the actual house and then sold it. No, they get more, because they do not need to pay capital gains taxes in order to get their hands on the cash. Keeping this extra cash out of the hands of the alleged bait-and-switch “victims” is the real point of the proposed regulations.

Don’t be trapped by your own rules. The law provides tax incentives for benefactors to create trusts that eventually pay their principal to charity. One key benefit is that such a trust can sell assets without paying capital gains tax. Without ever specifying exactly what it objects to, the Treasury has issued a series of warnings since 1994 to taxpayers who dare to take advantage of “a mechanical and literal application of regulations” to avoid capital gains taxes through charitable trusts. What’s wrong with following the regulations? An official in the IRS chief counsel’s office recently complained that some of these taxpayers “are using the [charitable remainder trust] for retirement.” This is a problem?

Now you know how the experts get around legislative gridlock to achieve their policy goals and still get home in time for dinner. You don’t like the results? Call your legislator — and be prepared to wait.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.