Tax laws are inherently complex, and the 2017 Tax Cut and Jobs Act hasn’t made finding ways to reduce tax drag easier for tax lawyers, especially those serving and catering to ultra-high-net-worth (UHNW) individuals and families.
While fiduciary duties should make objectives clear for investors and alternative investment vehicles such as hedge funds and venture capital, the need to achieve compelling risk-adjusted returns is not a passive exercise, but an unending and iterative battle against trends, the market, and the innate unpredictable nature of the entire global macroeconomic and financial infrastructure.
It specifically requires an ability to marry the investment world with the tax ecosystem in a quest to maximize after-tax returns and make investing in such strategies a worthwhile endeavor.
Prudent financial management requires an understanding of markets and the secular trends that underpin markets – including how they react, and how they change and evolve over time – well beyond running heuristic exercises and hoping for the best.
When operating in the world of ultra-high-net-worth taxable individuals and families, the degree of difficulty is even higher.
And yet, those advising UHNW individuals and family offices need to be even more specialized than ever.
Some are experts in the minutiae of hedge funds, derivative trading, venture capital and private equity. Others are analysts, data specialists or skilled at quantitative modeling. Ask any of them how the new tax law not only affects their clients, but their tax drag and you’re sure to get a confident response, albeit one that is likely absurdly uninformed and quite often, incorrect.
These days, as the financial stakes become greater — as does managing the finances of UHNW families — the complexity increases exponentially. To truly fulfill your obligations to clients requires a comprehensive knowledge of many moving parts, including investments, cross-border tax analysis, philanthropy and estate planning.
Often it takes a lifetime of experience and deep learning to attain an understanding of all the issues necessary not just to be mediocre, but among the best in managing the finances of ultra-high-net-worth families across multiple generations.
That knowledge is not just culled from a large amount of hard work and research, but also from attention to detail.
It is just destiny that this industry is ignorant of the most critical issues it faces. The important things are not sexy or terribly interesting. The impact of the tiny details is less sexy than potential benefits accrued just simply by investing in venture capital or hedge funds.
There may be a manager who thinks they’re “crushing it” on the investment side – for example, someone realizing 15% in gross returns.
But in reality, the new tax rules could make that initial, awe-inducing number closer to 3% return after factoring in total management fees, fund expenses, and the mandatory profit allocation that our ubiquitous third partner – Uncle Sam – takes every year.
One goal should be to reduce this partner’s allocation as much as feasibly possible without jeopardizing the underlying investment thesis.
And it is the same on the other side, where tax lawyers who should know better aren’t aware of the various ways to simultaneously leverage the ever-evolving financial system with the Internal Revenue Code.
More than ever, it is essential to understand how taxes and investments interact. However, professionals in one discipline generally don’t consider (or worse, don’t think to consider important) the other discipline as part of their job. This is especially true with market fluctuations, regulatory changes or unexpected evolutions to entire industries.
Each and every one of these factors can present treasure chests of opportunities for successful multi-generational planning for those tax attorneys who have devised an effective treasure map.
I have learned from experience that with changes there are always a plethora of opportunities.
However, too often, what the job actually entails is outside the realm of duties many believe are endowed to them by a job title, or they simply find the tax minutia and complexities not important.
If you are charged with doing due diligence on a hedge fund, and you plan to effectuate that task competently, it should be your fiduciary duty to take the foundational documents of the fund - i.e., the Private Placement Memorandum (PPM) and Due Diligence Questionnaire (DDQ) - that are likely to be 150 pages or more and compare them to the investment vehicle’s operating agreements (i.e., limited partnership agreement).
If you do this, you will often find mistakes and inconsistencies where one document says one thing, and the other something completely different.
A manager might have changed something at the last moment or a tax attorney or fund counsel missed a crucial detail. Misunderstandings like this can be portraited as a misrepresentation by a savvy plaintiff’s attorney that can create legal havoc in a courtroom.
For example, my firm recently reviewed fund documents for a hedge fund strategy our investment team was diligencing.
When I asked the manager and his chief operating officer about how the incentive allocation was structured, their response was completely incongruous with what the fund formation documents reflected.
They insisted I was wrong, but I adamantly urged them to review the documents with their fund counsel.
After seeking comment from his counsel, the manager realized our interpretation was correct.
We advised him how best to structure the incentive allocation for his new funds to maximize tax efficiency for him and his limited partner investors, which was not the approach of his current funds nor that of his advisors. His counsel agreed.
Guided by my anecdotal experiences as a tax attorney and my knowledge of the investment side as a CFA, this is one of the very first things I do.
I take the two documents, put them side by side, and make sure they are consistent.
No one wants to do this work, but it’s a vital task that goes beyond potential problems that could arise down the road.
What you learn, and then how you can leverage the acquired wisdom from this task, can lead to insights and an understanding of tax and financial regulations that will lead to an industry advantage that cannot be obtained in any institute of higher learning or a textbook.
On top of that, there are huge potential tax inefficiencies that may be expunged by someone with such a multi-disciplinary background.
As a tax attorney who migrated to the investment side, I obsess over both financial and tax knowledge and how these disciplines interact.
I am not alone, there are investors and tax attorneys in Boston, New York, Chicago, and elsewhere who crave all the information to do this job best. But we are a rare breed.
There are too few people advising UHNW clients who are doing this right these days.
I know this because I have lived it.
And in this column, I plan to share some of the incredible opportunities I’ve discovered by examining the pressing issues that ultra-high-net-worth families, investors and entrepreneurs should not just be aware of, but should be able to leverage to maximize returns and preserve wealth across generations.
There are many lucrative and exciting opportunities that have been created by the Tax Cuts and Jobs Act alone that my firm is capitalizing on for our UHNW families, and I’ll be sharing some of those opportunities here.
