It is, of course, most appropriate that financial advisors seek to prepare their clients in advance of a major liquidity event such as the sale of a business, a public offering, or a similar event. An experienced, knowledgeable, and creative advisor can figuratively perform magic if he or she has sufficient time to prepare for a liquidity event. To optimize results, the advisor will want to participate in structuring – even steering – the client’s participation in the event and will want to be well prepared for all of the possible event-related outcomes from a tax, estate planning, investment, cash-flow, and risk-management perspective.
Pre-event tax and estate planning techniques available to the advisor and the client, for example, include:
(1) Transfers to trusts, family limited liability companies, and other vehicles;
(2) Leveraging gifts through grantor-retained annuity trusts, intentionally defective grantor trusts, and similar vehicles;
(3) Charitable transfers;
(4) Section 83(b) and other tax elections;
(5) State tax and domicile planning; and
(6) Some of the more mundane tax strategies such as deferring income and accelerating expenses.
Yet, regardless of whether an individual has gone through a rigorous planning process prior to a substantial liquidity event, he or she should pursue an equally rigorous, comprehensive post-liquidity-event planning process. Needless to state, this process will vary depending on the nature of the event, the individual’s personal circumstances, and the macro and micro outlooks available at the time of the event. Nevertheless, there are several fundamental steps that must be considered following a liquidity event – even in the absence of pre-event planning.
1. Tax Planning
Most immediately, an individual who undergoes a major liquidity event will need to ensure that full consideration is given to the tax consequences of the event itself and whether, through strategic timing, tax elections, or further structuring, those consequences can be further optimized. For example, in the case of a public offering or similar event, simple questions such as when and in which year to sell any newly public securities can make a dramatic difference with respect to the potential deferral of the associated income, realization of any available capital losses, timing of state tax payments, and applicability of special taxes such as the alternative minimum tax.
In the context of a business or asset sale, an analysis should be performed to confirm all of the relevant tax attributes, including basis, holding period, capital account (if applicable), and tax character (i.e., capital asset or otherwise). The individual also will require advice on the taxation of any deferred sale payments such as contingent earn-outs and escrows. Questions surrounding the use of the installment method of accounting for any gains not only are critically important but also are compounded in complexity when considering the various ways that cost basis can be recovered or the fact that some states impose different rules regarding the application of the installment method.
More recently, yet another analysis became necessary – specifically surrounding the applicability of the net investment income tax under the Affordable Care Act. Many individuals incorrectly assume or even are advised that this tax applies to any sale of securities or assets that they own. In fact, this tax does not always apply, and exceptions for business-related sales where the individual has been actively involved in the business may very well be available – potentially saving him or her substantial amounts of tax.
In any event, it is prudent to ensure that an adequate reserve is established to pay the current and future tax liabilities generated by the liquidity event. This reserve should be segregated and invested in short-term, conservative, and liquid positions so as to ensure that funds are readily available when needed.
Finally, a new set of ongoing considerations may also arise if an individual’s financial circumstances change in a substantial way after a liquidity event. If, for example, the individual’s income shifts from primarily earned income to primarily investment-related income, a new tax strategy, including a plan for paying estimated taxes, must be adopted for federal, state, and local tax purposes. Capital loss utilization, the ACA net investment income tax, the alternative minimum tax, and the mere absence of most tax withholding regimes can represent an entirely different set of considerations under such circumstances.
2. Estate Planning
Estate planning does not end after a liquidity event. In fact, proper estate planning is a continuous, lifelong process.
Although much of the higher-impact estate planning should ideally occur prior to a liquidity event, substantial planning can still occur afterward. Annual gifts, transfers to trusts and family LLCs, and a variety of charitable planning techniques remain available even after the event and can considerably mitigate future estate taxes.
Yet, tax reduction is only one of the key estate-planning considerations following a liquidity event. Legacy-related and family-governance considerations may also be quite important. Some individuals will want to create family LLCs not only to facilitate the potential for discounted gifting but also to offer a structure for managing the family’s substantial and growing wealth – and even its legacy. Some will also want to consider the creation of family foundations, charitable trusts, or donor-advised funds so as to offer a clear, collaborative structure for achieving the family’s philanthropic objectives. A donor-advised fund or family foundation that fosters collaboration provides an excellent opportunity to share values and educate the next generation on financial responsibility, thus helping to ensure effective wealth transfer to future generations.
3. Investment Asset Allocation and Portfolio Rebalancing
a. General
A liquidity event, by definition, will change an individual’s overall asset allocation mix. Moreover, it could change the individual’s short- and long-term goals and needs, as well as impact the individual’s risk tolerance, time horizon, tax status, and other factors.
In turn, the individual will need to go through an intensive process first to establish a new investment policy (preferably in writing) and then to undertake a reallocation and rebalancing process. Diversification will remain important, but larger account values may generate opportunities to access investments, managers, and asset classes (e.g., certain alternative investments, private equity, and other private strategies) that previously may have been unavailable, thereby necessitating a completely fresh, opportunistic look at all portfolio strategies.
b. Publicly Traded Securities
Managing portfolio risk where an event includes the receipt of publicly traded securities often involves the potential additional complexity of securities regulations, company policies, and, of course, contractual arrangements. Diversification planning may include a host of arrangements, including trading plans, hedging transactions, liquidity arrangements, and income-enhancing techniques. Coordinating with tax advisors and counsel, as well as negotiation with investment banks, is critical.
4. Cash-Flow Planning
Despite the fact that a liquidity event will result in the conversion of one or more assets into cash, the event nevertheless may generate a need for a different approach to cash-flow planning. In many cases, for example, a business sale is accompanied by a reduction or elimination of traditional compensation income. In turn, it often is necessary to adjust the composition of an individual’s investment portfolio to produce levels of base cash flow sufficient to support the individual’s lifestyle and needs (which also may change after the event).
Other cash-flow considerations may include determining the best after-tax approach for dealing with any outstanding debt. Mortgage, investment, and business debts should be reevaluated in light of the cash infusion, possibly leading to whole or partial payoffs, which, in turn, require incorporation into the cash-flow plan.
5. Risk-Management Planning
a. Insurance
The realization of a liquidity event also requires a complete reevaluation of the insurance spectrum covering the risks faced by an individual. Most obviously, a substantial liquidity event may obviate, or at least change, the need for continued life insurance. Business-related insurance also may need to be changed, particularly in the context of a business sale.
Yet, the need for other types of insurance actually may become far greater. Personal liability coverage, for example, may need to be increased, along with the coverage limits and deductibles on related properties and automobiles. Similarly, property and liability insurance will need to be reviewed as cash is invested in new assets.
b. Trusts
Creditor-protection and similar trusts may be attractive for those experiencing infusions of substantial liquidity. Nevertheless, these trusts, which can offer additional protection from creditors, come with costs and should be considered carefully before utilizing them. Trusts can attract significant administrative fees and professional fees and may even create additional tax liabilities. These entities also often require the relinquishment of some control of the underlying assets, which many individuals ultimately cannot accept.
More conventional trusts should also be reevaluated after a liquidity event. Spendthrift provisions, trustee appointments and powers, and beneficiary provisions may require substantial attention in light of higher, more liquid asset levels.
c. Limited Liability Entities
LLCs, limited partnerships, corporations, and other limited-liability vehicles can also be deployed to offer insulation against future claims by creditors. Again, however, the use of these vehicles may have tax consequences and additional expenses, necessitating careful planning.
6. Professional Team Restructuring
In fact, all of the foregoing items require extremely careful planning. Therefore, perhaps the most important decisions that can be made following a liquidity event relate to the creation of the right team of experts to ensure the required level, depth, and breadth of planning.
This team may require a different composition than the team, if any, in place prior to the liquidity event. High-level expertise in the following areas will become critical: financial planning; investment management; legal structuring and advice; tax compliance; insurance planning; and intra-family governance. Experts in these areas can be retained independently, but some organizations are capable of providing all or most of the above services, potentially offering better coordination, efficiency, and integration of the services. In the absence of a single organization that can provide comprehensive services, another decision will need to be made: who will assume responsibility for coordinating the efforts of the various experts? Ideally, this leadership should be provided by a trusted advisor that has a fundamental understanding of all of the above considerations and experience in managing a multidisciplinary team of professionals.
In the end, all of the steps discussed above are important in ensuring that the most effective, optimal approach is chosen and executed following a liquidity event. Proper planning can create magic, especially when there is extensive coordination among professionals on the team and, of course, the client.
Michael Nathanson is the chief executive officer and president; Stephen Stelljes is the president of client services; and Nadine Lee is the president of the family office of The Colony Group, a national financial advisory company with offices in Massachusetts, New York, Virginia and Florida. The authors are grateful to Cary P. Geller, MBA, CPA, PFS, CFP, AEP, managing director of The Colony Group, for his contributions to this article.
