Ideas from Shaheen, Novoselsky, Staat & Filipowski for
Preserving Your Wealth
SNSF Newsletter - Issue 02-2 - November 2002
Alert - Review Split-Dollar Life Insurance Now
f you own life insurance under a split-dollar arrangement (where another party is paying the premium and is entitled to recover from the policy all prior premium payments), you should review the arrangement and make any changes now. IRS is in the process of issuing final regulations which will increase income taxes on these arrangements if changes are made after the regulations are issued. Often these arrangements need to be changed to reduce the cost of the insurance.
Reduce Estate and Income Taxes on Your IRA
You are probably aware that, after your death, the beneficiary of your IRA account may only receive 25% of its value because 75% may go to income and estate taxes, depending on the size of your estate, the income tax bracket of your beneficiary, and how rapidly you beneficiary withdraws funds from the account.
For example, if you and your spouse have an estate of $5,000,000 which includes your IRAs and your spouse’s IRAs totaling $1,000,000 payable to your child who is ordinarily in the top income tax bracket or who elects to withdraw the IRA funds in lump-sum, your child would receive only $250,000 from the IRAs after paying the applicable estate and income taxes.
It is possible to increase this amount from $250,000 to $500,000 by re-arranging the ownership of the assets in your IRAs.
To do this, your IRA custodians would exchange all of the assets in the IRAs for membership interests in a new limited liability company (“LLC”) organized by them and managed by you and your spouse. The value of the membership interests owned by the IRA custodians will be substantially less than the value of the LLC’s assets because the rights of the IRA custodians in those assets will be substantially less. In particular the IRA custodians as owners of membership interests will no longer have rights to withdraw or control the assets. It is this reduced value which reduces the applicable taxes thus increasing the amount which your beneficiary will ultimately receive.
This ownership arrangement offers many non-tax advantages as well, including centralized investment management, asset protection, and extend spend-thrift protection.
IRA Minimum Distributions
When it comes to taxes, reaching 70½ is an important milestone. That’s because you have to start taking minimum annual distributions from your IRAs when you reach 70½. If you’ve already retired from your company, you must also begin making withdrawals from your company’s retirement plan as well. If you don’t take these distributions, you could get hit with a 50% penalty tax.
When must these minimum distributions begin? If you reach age 70½ in 2002, you actually have until April 1, 2003 to take your first year’s distribution, namely the one for 2002. However, if you wait until 2003 to take the first distribution, you will also have to take a second distribution in 2003. That could lead to unpleasant tax consequences. For example, you may be pushed into a higher tax bracket for 2003. Additionally, you may be hit with a larger tax on social security benefits in 2003 and saddled with larger cutbacks for deductions such as medical expenses.
However, the decision whether or not to accelerate minimum distribution payouts is not an easy one and is not for everyone. Your overall financial picture must be taken into account. If this is your year to begin IRA distributions, you should promptly review your financial and tax situation to determine what method of distribution may be appropriate for your situation.
Defending Employment Related Claims
Documenting employment decisions is essential to successful defense of employment related claims. In the case of Zimmerman v. Associates First Capital Corp., a vice president of sales fired a female sales representative on performance grounds. The sales representative sued the firm claiming gender discrimination, relying upon her own sales reports and bonus statements as proof of her good performance. The company vice president had no documents to support his decision. He testified that he had destroyed all documents relating to the sales rep shortly after the termination. He had no memos, sales figures or other documentation concerning productivity for any other sales representative. The jury found the company liable for gender discrimination and awarded back pay, compensatory and punitive damages, plus pre-judgment interest and attorneys’ fees for a total exceeding $450,000. The judgment was affirmed on appeal. On appeal, the Appellate Court noted that the federal law and regulations require employers to keep employee records for a year after termination.
Documents that must be maintained by Employer include information on other similarly situated employees. The failure to keep such records allows a jury to presume that missing or destroyed documents would have been unfavorable to the employer’s case.
Documentation is necessary even in “at will” employment states. You can fire someone without cause, but you must preserve evidence that shows why a particular employment action was taken so that you can avoid charges of discrimination under Title VII of the Civil Rights Act (age, disability, race, sex or national origin).
Protecting Your Company’s ERISA Benefit Plan Fiduciaries
As a company owner, it is possible that you or others are deemed to be “fiduciaries” under the law. Fiduciaries of ERISA Benefit Plans include the Plan sponsors (employers), business owners, accountants, bookkeepers, investment advisors and Trustees named in the Plan itself. If you are a Plan fiduciary, you may be subject of claims by the Plan beneficiaries or the Department of Labor, if you mismanage plan assets or act in your own best interest, rather than in the best interests of the Plan and its beneficiaries.
Any person (including a business entity) may be an ERISA Plan Fiduciary if he has discretionary authority or control in the administration of the plan, exercises any authority or control with respect to the management or disposition of the plan assets, or provides or renders investment advice to the plan. As a Plan fiduciary, you are bound by general fiduciary obligations, including a duty to act in the best interests of the plan and the beneficiaries.
In addition to general fiduciary obligations, fiduciaries are prohibited (except in special circumstances) from engaging in certain transactions with “parties of interest.” If your company has a Plan, you and others may be unwittingly assuming personal liability. It is possible to avoid exposure to personal liability. You should consult with your attorneys if you may have such exposure.
Reasons to Engage in 1031 Like-Kind Real Estate Exchanges
IRS Code Section 1031 provides an exception to the general rule requiring current recognition of gain or loss realized upon the sale or exchange of property. Basically, Section 1031 is an incentive to defer taxes where substantial appreciation has occurred or where significant tax depreciation has been claimed. Under Code Section 1031(a)(1), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a “like-kind” which is also to be held either for productive use in a trade or business or for investment. Some reasons why you might consider an exchange of real property under this Section are as follows:
Preservation of equity by not paying tax on realized gain;
Generation of cash flow by exchanging unimproved land for income producing property;
Acquisition of property that is appreciating faster than the property transferred;
Consolidation of assets by exchanging many properties for one equal to or greater than their combined values;
Diversification of holdings and spread of investment risk among several smaller properties; and
Relocation of business facilities, even on a build-to-suit basis, without depleting equity by paying tax.
Investor News in Focus
Unscrupulous Stockbrokers
"Unscrupulous stockbrokers" earn their way to the Number 2 position in this year’s "Top 10" Investment Scams as listed by state securities regulators (NASAA). "Analysts Research Conflicts" finishes in Third Place this year. Many brokerage firms have been criticized. Consider the following information regarding Paine Webber, Merrill Lynch and Salomon Smith Barney.
PaineWebber and Enron
News of stockbroker Chung Wu’s plight at PaineWebber is disturbing. He was fired for telling his customers that they should sell their stock in Enron, albeit through an impermissible email message.
PaineWebber had conflicts of interests with its customers. That is because PaineWebber had a buy recommendation on the stock, had an investment banking relationship with Enron, managed the Enron stock option program and handled brokerage accounts for many Enron company executives.
On the other hand, stockbroker Wu was looking out for his clients’ best interest, and he was fired for doing so. That’s not right.
Merrill Lynch Stock Analysts Come Under Fire
News of the New York State Attorney General’s legal action against Merrill Lynch has undermined the trust that so many investors placed in Merrill Lynch and its highly touted independent and objective research and investment advice. Merrill Lynch denied the charges, but settled anyway for $100 million.
According to the press release issued by New York State Attorney General Eliot Spitzer, Merrill Lynch misled investors in what he described to be "a shocking betrayal of trust":
[T]he stock ratings were biased and distorted in an attempt to secure and maintain lucrative contracts for investment banking services.
As a result, the firm often disseminated misleading information that helped its corporate clients but harmed individual investors.
In Spitzer’s press release dated April 8, 2002, Spitzer offered some of his evidence, including internal email communications. According to Spitzer, these communications show "analysts privately disparaging companies while publicly recommending their stocks." Several stocks are at issue, including Aether System, Excite@home, GoTo.Com, InfoSpace, Internet Capital Group, Inc., Lifeminders, and 24/7 Media.
Move Over, Merrill Lynch: Salomon Smith Barney Alleged to Have Deceived Investors by Issuing Misleading Research Reports and Stock Ratings
New York Attorney General Eliot Spitzer now has set his sights on Salomon Smith Barney and corporate executives from some of the companies for which the brokerage firm provided investment banking and stock research coverage.
The lawsuit, filed September 30, 2002, alleges that Salomon Smith Barney engaged in a practice called “spinning”, whereby it allocated nearly risk-free shares of stock to executives of companies who chose Salomon Smith Barney to act as the companies’ investment banker for initial public offerings (IPOs). The lawsuit names executives at Qwest Communications, WorldCom, Metromedia Fiber Networks and McLeod USA, and alleges that they wrongfully reaped millions of dollars in IPO stock profits. According to the lawsuit, Salomon Smith Barney and its analysts (such as Jack Grubman) allegedly reaped millions of dollars in investment banking fees, “by covering the defendants’ companies with unduly optimistic research reports and buy recommendations”.
How did investors fare? The lawsuit alleges that investors were stuck “holding the bag”, losing “hundreds of millions of dollars when the stock in the defendants’ companies crashed”, because they never were informed of the arrangement between Salomon Smith Barney and the companies for which it provided investment banking and stock research coverage.
Particularly disturbing is the degree to which Salomon Smith Barney allegedly encouraged its research analysts to, in effect, defraud investors. Specifically, the attorney general’s lawsuit (which may be viewed at http://www.oag.state.ny.us/press/2002/sep/sep30c_02_complaint.pdf) makes several unsettling allegations, as detailed below, against Salomon Smith Barney (“SSB”).
SSB Research’s Ratings Were Not Independent, Objective or on the Merits
SSB issued research and ratings on over 1,000 U.S. stocks. SSB rated stocks as follows: Buy, Outperform, Neutral, Underperform, and Sell. Nonetheless, SSB had not one Sell rating, and only 15 (1.4%) Underperform ratings, according to the complaint.
SSB executives internally criticized SSB’s research coverage and ratings. For example, the attorney general alleges that the head of SSB’s Global Equity Research Management, John Hoffmann, described SSB’s ratings as the “worst” and “ridiculous on face”. He acknowledged that institutional and sophisticated investors knew that SSB’s "Neutral" rating did not mean Neutral but instead meant Sell. Hoffmann wrote in his "2000 Performance Review" that there was "legitimate concern about the objectivity of our analysts which we must allay in 2001".
Hoffmann’s sentiments were echoed by the global head of SSB’s retail stock-selling division, Jay Mandelbaum, who told Hoffman that SSB’s “research was basically worthless”.
Investment Bankers and Investment Banking Fees Influenced the Ratings
Investment bankers and stock research analysts must be separated and not influence each other. However, at SSB, the complaint alleges that:
Investment bankers wanted the highest research rating for their banking clients or potential clients to enhance their ability to garner
additional banking fees in the future. SSB’s structure and compensation procedures encouraged investment banking to exercise its
influence over analysts and their research ratings.
Indeed, the attorney general cites and quotes from several pieces of correspondence from John Hoffmann and others which demonstrates not only that SSB knew of the close relationship between investment banking and research analysts but also encouraged even closer ties, especially through fee sharing.
At a "Best Practices Seminar", hosted by SSB’s head of U.S. Research Management, Kevin McCaffrey, and by Jeffrey Waters, SSB’s Associate Director of U.S. Equity Research, research analysts learned “how to manipulate their financial models to support underwriting by SSB’s investment banking division”! The reason? Money:
And its clear…that Research is driving a lot of this [investment banking revenues] increasingly. And therefore, as a [research]
department our goal has to be, to be a really effective partner in terms of helping drive initiation, execution and everything else.
Because there is a lot of money on the table for this company [SSB]. And we’ll all benefit from it.
In fact, the attorney general alleges that in 1997, SSB paid what it called "Helper’s Fees" to analysts of $11 million. To ensure accuracy, "scorecards for analyst performance included as a specific metric the amount of investment banking fees SSB earned in each analyst’s sector of coverage and, for recent years, also included the SSB investment bankers’ evaluation of the analysts", according to the complaint.
SSB "Research Analyst" Jack Grubman
The complaint alleges that Jack Grubman was not a legitimate research analyst but, instead, was "in reality an investment banker". Grubman was paid an average of $20 million per year in compensation from 1998 to 2001. That compensation was not based upon his performance as a research analyst. In 2000 and 2001, Grubman had the dubious distinction of being chosen the worst of SSB’s more than 100 research analysts, as rated by SSB’s retail sales force.
The attorney general alleges that Grubman’s compensation was based upon his misleading actions.
Grubman failed to timely downgrade stocks on investment banking clients. Undoubtedly, arbitration claims and other actions will surge to redress the wrongs that investors have suffered.
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Here is a partial list of the stocks that Grubman recommended:
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1. WorldCom
2. Broadcom
3. Flag Telecom Holdings, Ltd.
4. Qwest Communications
5. Allegiance Telecom
6. McLeod USA
7. Metromedia Fiber Network
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8. XO Communications
9. Global Crossing
10. Winstar Communications
11. Verizon Communications
12. Frontier Corp.
13. Level 3 Communications
14. SmarTalk Teleservices Inc.
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15. Iridium LLC
16. Rhythm Netconnections
17. PSI Net Inc.
18. SBC Communications
19. Bell Atlantic
20. Sprint
21. AT&T
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Securities Arbitration News
On October 7, 2002, the Chicago Tribune ran an article entitled, "Change in Brokers’ Role Boosts Complaints". Attorney
James Eccleston frequently is quoted in discussing aspects of liability when financial advisers fail to protect ("hedge") investors’ portfolios from investment losses.
On October 7, 2002, attorney James Eccleston obtained the first arbitration award for a client whose financial adviser failed to hedge his large concentrated stock position resulting from the exercise of employee stock options from Cisco Systems.
For more information on issues highlighted here,
please contact one of the following
Shaheen, Novoselsky, Staat & Filipowski professionals:
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www.snsf-law.com
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of interest, visit our sister website:
www.financialcounsel.com
Shaheen Novoselky, Staat & Filipowski, P.C.
20 North Wacker Drive, Suite 2900, Chicago, Illinois 60606
(312) 621-4400 | (312) 621-0268 (fax)
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